The Guardian newspaper’s website MediaGuardian.co.uk said that, after a week of prevarication, the car giant has decided to go ahead and sue the people behind the advert on the grounds that it was damaging its reputation around the world and falsely linked the VW with terrorism.
"We are taking legal action but because it's early stages we cannot comment further," a Volkswagen spokesman told MediaGuardian.co.uk.
But the company privately admitted it cannot locate Lee and Dan, the London based advertising creative partnership claimed to have dreamed up the film, which has been seen around the world via the internet.
"We are prepared to pursue the two individuals but need to locate them to ensure the success of our legal claim," the company said in a private memo, details of which have been obtained by MediaGuardian.co.uk.
The report said the short film is made in the style of a TV advert and shows a man hopping into the car wearing the distinctive black and white kaffiyeh scarf commonly worn in the Arab world and made famous by the late Palestinian leader Yasser Arafat.
In the advert, the man drives around London streets before blowing himself up outside a restaurant - apparently killing himself but leaving the car intact. Then the slogan "Polo: small but tough", appears.
Volkswagen has consistently denied having anything to do with the advert, MediaGuardian.co.uk reported.
It said both Lee and Dan have apologised for the film, which they said had a £40,000 budget, but have refused to identify themselves or explain how it was funded.
However, MediaGuardian.co.uk says it tracked down the director of the spoof advert, Stuart Fryer, who reportedly said he was horrified by the reaction to the ad and that it was never meant to be seen by the public.
He disputed the estimate of the clip's £40,000 cost, saying it would have been "more like £400".
"If it cost that much I would like to know where the money went," Fryer told MediaGuardian.co.uk. "It was made in my spare time. It's remarkable what you can do for such a low budget.
"I just wanted it for show reel purposes, not seen by millions of people around the world.
"I don't want to offend people, I just want to make advertisements.I wanted to show it to the Saatchis and BBHs of this world."
This is the second online advertisement to cause controversy in the UK in the past year.
Last April, an campaign for Ford went badly wrong, leaving the US carmaker accused of bad taste over the depiction of its then-new SportKa decapitating a cat.
Ford's European operation and Ogilvy & Mather, its advertising agency, subsequently began an investigation into how a proposed ad – which both insisted had been rejected – had begun circulating on the internet.
Animal protection groups attacked the "abhorrent" advert, which showed a ginger cat having its head cut off by the sunroof before its dead body slid down the bonnet.