Residents of Battir, which straddles the Green Line, had in 2012 petitioned Israel's supreme court against defence ministry plans to build the barrier adjacent to and in places through their Roman-era terraces.
The agricultural community in the West Bank was granted UNESCO endangered World Heritage status in June.
On Sunday, the court announced it was erasing the petition because the defence ministry had said it did not intend to build in Battir at this time.
"At this stage the defence minister's stance is that constructing the fence on this route, while stressing its security importance, is not a priority," the court said.
It stressed that the state would have to inform the petitioners at least 60 days in advance if they intended to renew any bid to construct the barrier there.
The Battir area is one of the last remaining openings to the West Bank from southern Jerusalem.
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Israel says the barrier, which it began building after a wave of Palestinian attacks in 2002, is crucial for its security, while Palestinians see it as a land grab of territory they want for a future state.
Friends of the Earth Middle East (FoEME), which along with Battir residents filed the petition, called the court decision "an important win" and "a beacon of hope for a better future in our region."
Israel's Nature and Parks Authority as well as Jewish settlers of the area had also opposed building the barrier in Battir that would have cut off settlements south of Jerusalem from the city.
Battir is famed for its ancient terraces and Roman-era irrigation system, which is still used by villagers for their crops.
The landscape encompasses a series of agricultural valleys with stone terraces irrigated for the production of vegetables, vines and olive trees.
It is doted with ancient villages, fortifications and graves.
UN figures show that Israel has already built around two-thirds of the barrier -- a network of towering concrete walls, barbed-wire fences, trenches and closed military roads that will extend 712 kilometres (442 miles) when completed, separating the West Bank from Israeli territories.