The vote by 464,000 rank-and-file members ends five months of political deadlock since September's election.
The Social Democrats had been split between the party's leadership, which backed joining the coalition, and its radical youth wing, which did not.
Mrs Merkel has been in power for 12 years.
SPD voters approved continuing the coalition with 66% in favour. Vote counting went on through the night at the SPD headquarters in Berlin.
The chancellor faces a range of challenges, including strong opposition from the nationalist Alternative for Germany (AfD).
The anti-immigrant party entered the federal parliament for the first time in September and now makes up the largest opposition group.
The Social Democrats (SPD) suffered their worst ever election result and many blamed their coalition with Mrs Merkel's Christian Democrats (CDU/CSU) for that poor performance.
Mrs Merkel had tried and failed to form an alliance with the liberal Free Democrats (FDP) and the Greens.
She was forced to pay a higher price for continuing the existing coalition - the new finance minister will be a Social Democrat.
The end to uncertainty, including the possibility of fresh elections, will be greeted with relief in the European Union's institutions, where Germany, Europe's largest economy, is a major influence.
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