Labour had sought to suspend Mr Lally from the party for 18 months and bar him from office following allegations that he and others were involved in a 'trips for votes' scandal (LGC, 25 September 1997).
He took the case to judicial review, which was due to be heard in the Court of Session next week. However, this week he was told the party did not intend to contest it.
Mr Lally said: 'I'm obviously very pleased the matter is over. But I can't say I'm surprised. The situation is that the allegations were so lacking in substance that they wouldn't have stood up to the scrutiny of Scottish law.'
Mr Lally added: 'I've always held this childlike belief that honesty, integrity and justice would prevail at the end of the day.
'The question is how to sustain that belief when you are being assaulted by political pygmies.'
Of his detractors, he said: 'Off-the-record accusations made by influential people within the party are unacceptable. I regard them as the last refuge of the scoundrel.'
A spokesman for Mr Lally said the question of costs and damages was being pursued by his lawyers.
Mr Lally's case against the council continues. He is contesting a move by Glasgow to change its standing orders to allow it to remove a lord provost from office. Glasgow leader Frank McAveety said: 'The council must pursue as a point of principle its right to remove people from office. But this must be detached from any consideration of Pat Lally as an individual.'
The case is due to be heard in in February - around two months before Mr
Lally is due to leave office.
The Scottish Labour Party was unavailable for comment.