Ifo said its business climate index fell to 90.1 from an upwardly revised reading of 92.2 in December. A Reuters poll had forecast a January reading of 91.8.
"The second Corona wave has temporarily ended the recovery of the German economy," Ifo President Clemens Fuest said in a statement.
Chancellor Angela Merkel and state leaders agreed last week to extend a lockdown until mid-February as Germany, once seen as a role model for fighting the pandemic, struggles with a second wave of infections.
Ifo economist Klaus Wohlrabe told Reuters the economy would stagnate in the first quarter of the year, adding: "The German economy is starting the year with little confidence."
The economy is likely to reach its pre-pandemic levels in mid-2022, according to a draft document prepared by the economy ministry and seen by Reuters on Monday.
In a telling sign of corporate nervousness, Ifo's expectations index fell to its lowest level since June, confounding expectations for a rise.
Unprecedented government rescue and stimulus measures helped lessen the shock of the pandemic in Germany last year, when the economy shrank by 5.0%, less than expected and a smaller contraction than during the global financial crisis.
But the renewed lockdown measures are suppressing economic activity and confidence. Ifo's index on current conditions fell to its lowest since September.
"Fear is back," wrote ING economist Carsten Brzeski. "It will take more momentum in the vaccination schemes and a further reduction in the number of infections before the economy can take off again. It currently looks as if it will take at least until spring time before this will be the case."
Highlighting the impact of the COVID-19 pandemic on German industry, carmaker Volkswagen said on Friday profit almost halved last year because of the pandemic, but a rebound in premium car sales in China and stronger deliveries in the fourth quarter helped keep it in the black.
The Federal Statistics Office will publish gross domestic product figures on Friday for the fourth quarter, when some lockdown measures had already been implemented. The statistics office said earlier this month growth probably stagnated in the fourth quarter.
The government expects the economy to grow by 3% this year, a government official told Reuters on Friday, a sharp downward revision from last autumn's estimate of 4.4% caused by November's imposition of a second coronavirus lockdown.
(Writing by Paul Carrel; editing by Maria Sheahan and Larry King)
By Paul Carrel and Rene Wagner