As head of the Federal Bureau of Investigation, Lieberman would have overseen the investigation into potential Trump campaign links to Russian meddling in last year's election, the very same probe that the lawyer, Marc Kasowitz, is expected to defend Trump against.
Trump's acknowledgement last week that Lieberman led his list of possible nominees brought strong criticism that it would give the White House leverage over the FBI's investigation, after Trump fired director James Comey.
"With your selection of Marc Kasowitz to represent you in the various investigations that have begun, I do believe it would be best to avoid any appearance of a conflict of interest, given my role as senior counsel in the law firm of which Marc is the senior partner," Lieberman wrote in a letter to Trump.
Lieberman, the Democratic nominee for vice president in 2000 who later left his party to become an independent, joined the law firm Kasowitz, Benson, Torres & Friedman after he left the Senate in 2013.
Kasowitz and David Friedman, formerly a partner in the firm, have both represented Trump in lawsuits. Trump named Friedman his ambassador to Israel early this year.
The potential choice of Lieberman after Comey's firing added to fears that Trump is trying to stifle the probe into possible collusion between the campaign and Russia.
Trump has branded it a "witch hunt" as parallel investigations by the FBI and several committees in Congress have homed in on links between a number of campaign aides and Moscow.
Last week former FBI director Robert Mueller was named as an independent special counsel to lead up the Justice Department and FBI probe.
Lieberman's withdrawal leaves no clear frontrunner for the job. According to reports, Trump is considering former congressman Mike Rogers, former George W. Bush homeland security advisor Fran Townsend, and acting FBI director Andrew McCabe for the job, among others.
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