The director had urged a boycott of the festival if the £300 funding to allow Tali Shalom Ezer to travel to show her film was accepted, The Times reports.
Loach said: "The massacres and state terrorism in Gaza make this money unacceptable."
Festival organisers said: "We consider the opinions of the film industry as a whole and, as such, accept that one filmmaker's recent statement speaks on behalf of the film community. Therefore we will be returning the funding issued by the Israeli embassy."
Former Channel 4 chief executive Sir Jeremy Isaacs said: "Ken Loach has always been critical of censorship of his own work, albeit it was many years in the past.
"The idea that he should lend himself to the denial of a filmmaker's right to show her work is absolutely appalling."
A festival spokesman confirmed its return of the grant but said that it would fund Shalom Ezer's visit to Edinburgh out of its own budget.