Police have been investigating Gheith over suspicions he was involved in the Palestinian Authority's arrest in October of America-Palestinian Issam Akel, who is accused of involvement in selling an east Jerusalem building to Jewish buyers.
Such sales are considered treasonous among Palestinians concerned with Israeli settlers buying property in annexed east Jerusalem.
Police also suspect Gheith of recruiting Palestinian residents of Jerusalem to the PA armed forces, which Israel says violates the 1993 Oslo accords. Palestinian officials have condemned his arrest and claim it is intended to pressure the Palestinian leadership over Akel's case.
Israelis, as well as US ambassador David Friedman, have called for Akel's release.
Geith's lawyer, Rami Othman, said the court's decision to release his client to house arrest proved the case was not serious.
"The mountain gave birth to a mouse," Othman told AFP.
"They want to harass him," he said following Sunday's hearing.
He said they did not want him to remain Jerusalem governor. "They don't like the position." Gheith had been arrested for several days in October and was also taken for questioning a number of times in recent weeks, with his office raided on November 4.
Israel's public broadcaster Kan said that ending the coordination was a means in pressuring the Palestinians to release Akel from detention. Security officials in Israel would not comment on the issue.
Israel occupied east Jerusalem in the 1967 Six-Day War and later annexed it in a move never recognised by the international community. It considers the entire city its capital, while the Palestinians see the eastern sector as the capital of their future state.
PA activities are barred from Jerusalem by Israel.