Lyricist and adman Prasoon Joshi replace Pahlaj for a three-year term.
According to an ET Now tweet, Nihalani, whose tenure as CBFC chief was marred by controversy, was removed from his position on Friday.
Earlier it was reported by the Times Of India that a meeting of CBFC members was called by Nihalani in Thiruvananthapuram on July 28.
Nihalani has found himself embroiled in a number of controversies since taking over as chairman of the CBFC.
The most recent film, which had to bear the brunt of the sacked CBFC director was "Lipstick Under My Burkha", which was denied certification for being "explicit", "abusive" material and "too lady oriented". The government replaced Pahlaj Nihalani, who has hogged headlines for his controversial decisions, with Joshi in a surprise announcement today. Joshi has been awarded with the National Award for best lyrics twice. Honoured with Padma Shri, the National Award victor penned the theme song for Prime Minister Narendra Modi's Swachh Bharat Abhiyan and other campaigns.
Mukesh Bhatt, film producer and president of the Film and Television Producers Guild of India, said, "The appointment of Joshi, a writer par excellence and man who is more evolved as a creative person, as the head of CBFC is a good sign".
Last year, he raised objections to several scenes in the movie "Udta Punjab" that chronicled the drug menace in the state. He comes from the advertising background and will have a modern point of view.
"I am happy with this decision ... this had to happen", film-maker Ashok Pandit, a member of the outgoing panel, told Reuters over the phone. "Prasoon, Vidya and I are on the same page".
Before cracking down on a variety of movies, Nihalani had produced a string of films including "Paap ki Duniya", "Aag ka Gola", "Shola aur Shabnam", "Aankhen" and "Talaash: The Hunt Begins".