Berlin's move, in response reaction to an Israeli plan to take control of Gaza City, marks a drastic change of course for Germany, long one of Israel's staunchest international allies.
Merz expressed "deep concern" at the suffering of Gaza's civilians.
It was "increasingly unclear", he said, how the latest Israeli military plan would help achieve the aims of disarming Hamas and freeing the remaining Israeli hostages.
"Under these circumstances, the German government will not authorise any exports of military equipment that could be used in the Gaza Strip until further notice," he said in a statement.
Netanyahu spoke to Merz later Friday to express his "disappointment", said a statement from the prime minister's office.
"Instead of supporting Israel's just war against Hamas, which carried out the most horrific attack against the Jewish people since the Holocaust, Germany is rewarding Hamas terrorism by embargoing arms to Israel," it said.
- Disarming Hamas 'imperative' -
Germany's Central Council of Jews also called Merz's decision "disappointing", saying the government should "correct course" and increase pressure on Hamas instead.
Israel has until recently enjoyed broad support across the political spectrum in Germany, a country still seeking to atone for the World War II murder of more than six million Jews.
Between the Hamas attack of October 7, 2023 that started the Gaza war and May this year, Germany approved defence exports worth 485 million euros ($565 million) to Israel.
The deliveries included firearms, ammunition, weapons parts, electronic equipment and armoured vehicles, the government said in June.
Merz reiterated that "Israel has the right to defend itself against Hamas' terror" and that "the release of the hostages and negotiations on a ceasefire are our top priorities".
"The disarmament of Hamas is imperative. Hamas must not play a role in Gaza in future," he said.
But "the new military push agreed by the Israeli security cabinet makes it increasingly unclear how these goals are to be achieved", he added.
- Gaza suffering 'unbearable' -
Merz's decision is a dramatic step for Germany, where the chancellor's tone towards Israel had been sharpening in recent months as the dire humanitarian situation in Gaza deteriorated.
Vice Chancellor Lars Klingbeil of the Social Democrats welcomed the "just decision", saying "the humanitarian suffering in Gaza is unbearable".
A poll published this week by public broadcaster ARD found that 66 percent of Germans expected the government to exert greater influence over Israel to change its actions in Gaza.
However, while often voicing concern, Germany had so far avoided major concrete steps.
It refrained from following France, Britain and Canada, which have announced plans to recognise a Palestinian state in September, arguing recognition must come at the end of Israeli-Palestinian negotiations.
Berlin has also opposed the suspension of the EU-Israel Association Agreement, which had been under review by the bloc.
Global alarm has been growing over the suffering in Gaza, where a UN-backed assessment has warned that famine is unfolding.
German air force planes have joined others with humanitarian aid airdrops over the war-battered coastal territory.
Merz said that "with the planned offensive, the Israeli government bears even greater responsibility" for providing aid to Gaza and again urged "comprehensive access" for UN agencies and aid groups.
He also said his government had urged Israel "to refrain from taking any further steps toward an annexation of the West Bank".
Last month, 71 members of Israel's 120-seat parliament, including members of Prime Minister Benjamin Netanyahu's right-wing coalition, passed a motion calling on the government to annex the occupied West Bank.
The German-Israeli Society, which promotes closer ties between the two countries, condemned Merz's move and pointed to a $3.5-billion deal under which Germany had agreed to buy Israel's Arrow-3 anti-ballistic missile shield.
The group said that "if Israel were to retaliate in arms deliveries to Germany, the future of German aerial defence looks bleak".
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