In the first visit by a German leader to the island, Merkel lauded Greek Cypriot President Dimitris Christofias for his "courage and creativity" in talks with Turkish Cypriot President Derviş Eroğlu that are now in their third year with limited progress to show for it.
But she scolded the Turkish side for failing to keep up with Christofias in peace efforts.
"We see that you are taking many steps, and we also see that the Turkish side is not responding accordingly to these steps," Merkel said after talks with Christofias in the divided capital. "Your steps show that you are prepared to come to a compromise."
Cyprus was split into a Turkish Cypriot north and a Greek Cypriot south in 1974 when Turkey intervened after a coup by people who wanted to unify the island nation with Greece.
The dispute is hampering Turkey's troubled EU membership bid and holding back closer EU-NATO cooperation. NATO member Turkey has blocked formal NATO-EU relations, while Greek Cyprus has vetoed Turkey taking part in EU defense activities.
Turkey began entry talks with the EU in 2005, but negotiations on several policy areas have stalled or been suspended because Turkey refuses to open its ports to trade with Greek Cyprus since it does not recognize the Greek Cypriot government.
Merkel said her government wants Turkey's EU entry talks to continue "irrespective of what the decision will be at the end," but warned that they won't conclude without Ankara opening its ports to Greek Cypriot trade.
Turkey's entry talks cover 35 different areas, or "chapters." Of these, only 11 have been opened in the last five years.
"As long as Turkey doesn't [open its ports to Greek Cyprus], it cannot close any chapters and none have closed until now," Merkel said.
Christofias said Greek Cyprus supports Turkey's EU bid but that Ankara must first live up to its obligation to recognize the Greek Cypriot government. He said he remains steadfast to his vision of turning a reunified Cyprus into a regional "bridge of friendship."
The German chancellor thanked Christofias for hammering out "a strategic plan of cooperation" between NATO and the EU, despite the difficulties, saying a Cyprus peace accord was the best way to remove all obstacles.
Merkel's five-hour working visit to the island included a stop at a German cultural center straddling the United Nations controlled buffer zone in the divided capital, eerily reminiscent of once-divided Berlin.
The German leader said she understands the island's division on an emotional level but doubted whether German reunification could be used as a model for Cyprus because of "many practical differences" between the two countries.
She said the German reunification experience could prove useful once Cyprus talks are further intensified.