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Sister Mary Eliza, the head of Missionaries of Charity convent, was arrested late November for her failure to disclose an underage pregnancy at the Prem Children's Home at Moratuwa, a Colombo south suburb. The nun who hails from Kerala, was already on court bail.
The criminal investigation department, which questioned 55 people, concluded that there were no grounds to charge her with selling children or with failing to report under-age pregnancies.
It said all adoption procedures run by the sisters were fully legal. Sister Mary Eliza was present in the court.
The National Child Protection Authority reported to court that the attorney general had advised the release of the sister Mary Eliza. Head of the local Catholic Church, Cardinal Malcolm Ranjith, had vowed to stay away from state functions or state organised events in December in protest against the raid on the home.
The cardinal, while denying that the Prem Children's Home was a baby farm which sold babies of unwed teen-aged mothers, accused the police of framing the case.
The police said they had acted on a complaint by the National Child Protection Authority who wanted the home probed for suspicious activity.
A week back, the Sri Lankan government had apologised to the Catholic church.
"This is a complex and sensitive problem. On one hand there was the law. But if there were shortcomings in the way the raid was conducted, we need to rectify them," Keheliya Rambukwella, minister of media and government spokesman, said.