MVV Umwelt, which has faced intense pressure from local residents, said it would concentrate its efforts on a proposal for an Energy from Waste (EfW) plant at Devonport Dockyard's North Yard.
The decision leaves just two sites in the running to handle domestic waste for Plymouth, Torbay and South Devon.
The planned £100million incinerator is being commissioned for the South West Devon Waste Partnership, which includes Plymouth City Council.
A second waste firm, Viridor, has already submitted a planning application for an incinerator at New England Quarry, south of Lee Mill.
Viridor has said that it might go ahead, regardless of the outcome of the bidding.
The preferred bidder will be announced early in 2011.
Paul Carey, managing director of MVV Environment, MVV Umwelt's UK subsidiary, said: "North Yard offers many environmental and economic advantages over Ernesettle."
He said they had agreement in principle to provide steam and electricity to the Naval Base.
MVV is refining its proposal for the North Yard site, which is in the Weston Mill area bordering Blackies Wood.
There was also the potential to offer any surplus heat to a wider district heating network.
Geraldine Lane, chair of the anti-incinerator group Stifle, said: "This is really good news for the greenfield site at Ernesettle, but in terms of those of us who don't want an incinerator at all it remains a problem.
"I know the community would really like to have the land returned as a sports facility, or perhaps used as a nature walk or a park."
Ernesettle could still be used for handling waste according to Plymouth City Council's planning framework.
Mrs Lane said: "I don't see a problem with having an area recycling facility there, because Plymouth is desperately short of recycling."
Gary Streeter, Conservative MP for South West Devon, said the decision was not unexpected.
"North Yard has a lot going for it, not least its proximity to commercial buildings and ease of access from the Parkway through Camel's Head.
"I am hoping we can persuade the waste partnership that Lee Mill isn't suitable."
Campaigner Geoff Hillier said he was opposed to incineration in principle.
All waste should be sorted for recycling and composting, he said, with the small residue going to landfill.
Germany recycled 70 per cent of its waste, compared with Plymouth's 30 per cent, he said.
Joe Ellison, Saltash Independent councillor, said: "We're absolutely delighted that Ernesettle is off the agenda. It would have affected Saltash as much as Ernesettle. This is a real cause for celebration.
"We'll keep a close eye and monitor whatever proposals there are for this site in future."
When told the news, Anita Brandon, who lives in Ernesettle Close, overlooking the site, said: "That's marvellous. Being on top of the hill, we'd have got it. Some days even now we get a stench from down there."
Stephen Curtis, another neighbour, said Ernesettle Lane, leading to the site, was unsuitable for the extra traffic that an incinerator would have generated.
Since Chelson Meadow landfill site closed in 2008, Plymouth's waste has been taken to Lean Quarry near Liskeard.
Faced with escalating landfill taxes and fines, the city is under pressure to find a solution to its waste problem.