His arrest means Schaefer is likely to face jail for the sexual abuse of young boys, for which he was convicted in absentia in November last year after fleeing Chile.
But Schaefer also faces charges of child sex abuse in Germany that go back to the late 1950s.
Schaefer, who is in his 80s, has been denounced by former followers and by human rights campaigners.
For them, his capture signals the end to decades of impunity for what they allege are his strange and terrible crimes.
Paul Schaefer was a medic in Hitler’s army during World War II. After the war, he set up an evangelical ministry and a youth home, purportedly to care for war orphans.
But he was charged with sexually abusing two boys – and in 1961 he fled to Chile, reportedly accompanied by some 70 followers.
There, in a lush valley in the Andean foothills, he set up Colonia Dignidad – now renamed Villa Baviera.
The colony near the city of Parral, some 350km (220 miles) south of Santiago, grew to about 300 members – mostly German immigrants, or their descendants, but including some Chilean followers.
The 137-sq-km (53-sq-mile) Colonia Dignidad boasted a school, a hospital, two airstrips, a restaurant, and a power station, and reportedly made millions of dollars through a diversified range of businesses, including agriculture, mining and real estate.
It won over local people by offering jobs and free schooling and hospital care.
Details of life in the colony are hard to verify. Some visitors have described a scene from 1930s Germany, with women wearing aprons, with their hair in pigtails, and men in lederhosen.
Defenders say the members of the colony may be eccentric, but they are harmless, and in fact do good.
“I know them, and I like them,” Otto Dorr Zegers, a prominent Chilean psychiatrist who has worked in the Colonia Dignidad hospital, told the New York Times.
“Their ideology is a little bit old-fashioned, like that of the Mennonites who went to the United States, but nothing justifies the co-ordinated, synchronised lies and distortions that have been invented about them.”
But “defectors” from the camp paint a more sinister picture. His accusers say Colonia Dignidad was Schaefer’s fiefdom, where he was worshipped as a god.
They say residents, who are never allowed beyond the gates of the camp, are kept strictly segregated into genders – so much so that the birth rate of the camp is extremely low.
Residents are taught to shun sexual desires – with electric shocks administered to the genitals of young boys, former residents say.
And they accuse Schaeffer of the almost daily sexual abuse of young boys. Horror stories have emerged of the young sons of poor local families “disappearing” within the barriers of the compound.
But the story of Paul Schaefer is not confined to the perimeter fence of the colony – topped with barbed wire, studded with searchlights, and overlooked by a watchtower.
It goes right to the heart of the Chilean state during the iron rule of Gen Augusto Pinochet in the 1970s and 1980s – a period with which Chileans are still struggling to come to terms today.
The son of Manuel Contreras – the head of Dina, Chile’s now-disbanded notorious secret police – has told the Los Angeles Times his father first visited Colonia Dignidad with Gen Pinochet in 1974.
He has spoken of the warm relationship that grew between his father and Schaefer.
Former political prisoners of Gen Pinochet have testified to a warren of stone-walled tunnels under the colony, where they were taken to be tortured with electric shocks to the strains of Wagner and Mozart.
The Truth and Justice Commission, which investigated human rights abuses during Gen Pinochet’s rule, backs such allegations.
And despite decades of allegations concerning the sexual abuse of boys within the compound, charges were not filed against Schaefer until 1996 – six years after Chile began its return to democracy.
Thanks to Schaefer’s close links with Chile’s ruling elite, the colony was able to operate with impunity as a “state within a state”, said a Chilean congressional report.
Critics say elements within Chile’s ruling establishment would still prefer to keep details of his involvement with Gen Pinochet’s government concealed.
They say Chile must confront such allegations if it is to complete the process of coming to terms with its past.