The Nazis, the Jewish banker, and the battle for two priceless Picassos

The paintings are not only priceless, but they have been among the star attractions at New York's Museum of Modern Art and the city's equally renowned Guggenheim Museum for more than four decades. Both are early Picassos painted at the beginning of the 20th century – before the two world wars that would engulf Europe and ultimately lead to the current blockbuster of a legal battle.

One of the canvases is Le Moulin de la Galette, a Picasso painted in 1900 that, unlike the artist's later works, appears to ape the French Impressionists with its colourful depiction of dancing couples in fin de siècle top hats and flowing dresses at a lamp-lit venue somewhere in or near Paris. The other is Boy Leading A Horse, painted just six years later. This work, sparsely executed in tones of black, grey and brown, already betrays the radically different sculptured style that was later to become Picasso's hallmark.

Before Adolf Hitler was swept to power in Germany, the two Picassos belonged to one of the leading figures in a German Jewish community that had once played a key role in giving both the country and its capital, Berlin, a reputation as a centre of intellectual excellence.

The paintings were owned by Paul von Mendelssohn-Bartholdy, a prominent German-Jewish banker and art collector and a descendant of the composer Felix Mendelssohn and Moses Mendelssohn, one of Germany's early 19th-century philosophers during its Age of Enlightenment. The family's restored residence in central Berlin, where a private bank was founded more than 200 years ago, is today a tourist attraction.

Now, some 63 years after that Jewish community was systematically annihilated by the Nazis and their henchmen, its surviving heirs have launched what promises to be a spectacular legal battle to have the works returned.

The Mendelssohn-Bartholdy heirs are all German and Swedish citizens of Jewish ancestry. The dispute is intriguing because they are demanding that the Picassos be returned by American museums where powerful figures such as Ronald S Lauder – the Estée Lauder cosmetics heir, art collector and World Jewish Congress President – wield considerable influence.

Because of his position and his role as honorary chairman of the New York Museum of Modern Art (MoMA), Mr Lauder was instrumental in drawing up the so-called "Washington Declaration" under which 44 countries signed an agreement on the restitution of artworks that disappeared or were sold off during the Nazi era.

Yet Mr Lauder has declined to comment on the current dispute. Instead of discussing the issue with the heirs, the MoMA and Guggenheim museums have flatly rejected the claims. Lawyers for the two galleries have applied to the New York District Court, asking it to declare that they are the rightful owners of the paintings. An official hearing is expected this autumn.

So is Mr Lauder about to be hoist by his own petard? Julius Schoeps thinks he will be. The 66-year-old Potsdam historian is a descendant of Paul von Mendelssohn-Bartholdy and, along with his lawyer, John Byrne, is spearheading the battle to have the paintings returned to 26 descendents. He agrees with Mr Lauder's description of wrongfully appropriated paintings as "the last prisoners of war".

Mr Schoeps knew nothing of his ancestor's enthusiasm for art until five years ago, when he was visited by a Canadian van Gogh expert. She told him that his great uncle, Paul von Mendelssohn-Bartholdy, once owned an extensive collection of paintings that included five Picassos, eight van Goghs and works by Rousseau, Monet and Renoir.

After conducting some research, Mr Schoeps established that his great uncle's first wife, who was Jewish, had been friendly with the art dealer Alfred Flechtheim, who had helped the couple build up an impressive private collection. But in 1933, a few months after Hitler came to power, the banker was dismissed from all his public positions and his assets began to dwindle.

In the spring of that year, he began sending his paintings abroad. The five Picassos landed in Basel, where the art dealer Justin Thannhauser took charge of them. The next year the banker told him he was ready to sell for a good price. The five paintings were entered on Thannhauser's books on 31 August 1935 along with 200 other paintings, which suggests that they were not actually bought on that day.

Boy Leading A Horse was bought for a "reasonable price" by William S Paley, the American founder of Columbia Broadcasting System (CBS) in 1936. Paley later became a member of the MoMA board and in 1964 he presented the painting to the museum as a gift. Apparently, he was not informed who the original owner was.

Thannhauser presented Le Moulin de la Galette to the Guggenheim in 1963, declaring that he had obtained the work from Mendelssohn-Bartholdy in "ca 1935". But the real circumstances under which he acquired the five Picassos is one of the key questions in the current dispute. There is no documentation showing that Thannhauser bought them. Mr Schoeps assumes that the art dealer was in debt and simply stole the paintings.

Mendelssohn-Bartholdy died in Berlin in May 1935, aged 59 – reputedly after being attacked by a Nazi thug. But three months before his death he declared in his will that his second, non-Jewish, wife, Elsa, should be his heir and that after her death the inheritance should pass on to the banker's four sisters. The declaration included a hand-written insert which stated that Elsa Mendelssohn-Bartholdy had already received the banker's paintings as a "wedding gift".

Mr Schoeps argues that the insert indicates that the whole arrangement was a "persecution agreement" – a typical legal device used at the time to ensure that artworks were kept out of Nazi hands. He insists that it provides proof that the banker sold his works under duress from the Nazis – the key issue in the current legal battle.

By contrast, the New York museums claim that as a widow, Elsa would have been the rightful owner of all the paintings since their marriage in 1927 and that as a result the works were sold by an Aryan who was not subject to any Nazi persecution. The museums' lawyers also maintain that the family was dominated by protestants such as Elsa, who "mitigated the impact of Nazi anti-Semitism" on the banker.

Mr Schoeps regards this last assertion as a "cynical claim". He is convinced that like many other German-Jews in the early 1930s, his great uncle sent his pictures to Switzerland in order to fund an eventual escape. He maintains that he would never have sold the paintings if the Nazis had not taken power and that his great uncle fitted the Nazi cliché of a "moneyed" Jew. "Justice is our main concern. After all this time we would like clarification," he insists.