The Vatican went to court over the manipulation of a picture of Pope Benedict XVI that showed the pontiff kissing the imam of a Cairo mosque, ANSA reported.
The Italian fashion house has a reputation for provocative advertising.
Vatican spokesman Federico Lombardi said Benetton has publicly acknowledged it "violated the sensibility of the faithful" and recognizes that the image of the Pope is to be respected.
The Vatican dropped the lawsuit in exchange for a formal apology from Benetton and a donation to a Catholic charity.
Benetton said it did not intend to offend Catholics or Muslims.