Police received a complaint after unnamed Syrian-born 23-year-old used a picture of the ISIS flag as profile picture.
Prosecutors then took up the case but decided not to pursue further legal action.
The flag, which is seen as a hate symbol similar to that of the Nazi swastika, has not been tried in Swedish courts.
Under Swedish law, minority groups are protected from racial abuse and other hate crimes.
Yet due to the fact prosecutor Gisela Sjövall deems Daesh hate all groups, it does not therefore persecute one particular ethnic group.
Ms Sjövall said: “You could say that merely waving a flag of IS in the current situation can not be considered hate speech. It is not an expression of disrespect towards any [particular] ethnic group.
“IS expresses every kind of disrespect, but it’s against everyone except those who belong to IS itself. There is the dilemma, it [offends] too big a group.
“It has been said there could possibly be some form of incitement, that is urges others to commit criminal acts such as murder, but that is not the case.”
She added that because the Swastika was intrinsically linked to inciting anti-Semitism, this contravened Swedish laws.
Ms Sjövall added it may contravene Swedish law in 10 years.
The ruling has sparked outrage on social media.
Trumpoli tweeted: “Sweden is officially a “nutcase” RIP the lovely Scandinavian country. We”ll miss you.”
Alex Pierson wrote: “ISIS hates everyone equally so they get a pass!? What in God”s name is happening in this world?”
The defendant has denied being a supporter of the sickening death cult.
The flag used by ISIS has been used in Islam for hundreds of years without offensive connotations but has been adopted and defiled by the jihadis – something which lawyer Bjorn Nilsson HP used in defence of his client.