Joshi was appointed with immediate effect for a period of three years or until further orders, the information and broadcasting (I&B0 ministry said in a release.
Joshi, 45, was awarded the Padma Shri in 2015 for his contributions towards the field of arts, literature and advertising.
He had also penned the anthem for the Swachh Bharat Mission. He has received a number of awards, including the National Award for best lyrics twice.
The government also reconstituted the existing board. The new members are Gautami Tadimalla, Narendra Kohli, Naresh Chandra Lal, Neil Herbert Nongkynrih, Vivek Agnihotri, Waman Kendre, Vidya Balan, T S Nagabharana, Ramesh Patange, Vani Tripati Tikoo, Jeevitha Rajasekhar and Mihir Bhuta.
Nihalani's three-year tenure was to end in January next year.
"The order about Prasoon Joshi being appointed as the new chief of CBFC (Central Board of Film Certification) also says his tenure is for three years or till further orders. But this order came before three years (of Nilahani's tenure ending)," Anurag Srivastava, chief executive of CBFC, said.
Since his appointment as the head of CBFC in January 2015, Nihalani made headlines for a number of controversial moves and statements.
"... the central government is pleased to appoint Prasoon Joshi as chairperson of CBFC in an honorary capacity from August 11, for a period of three years or until further orders, whichever is earlier," the release said.
Director Vivek Agnihotri, who was appointed as one of the members of the board, told PTI from the US that "with people like Prasoon Joshi and Vidya Balan, we all are very progressive. We are not outsiders and will look at it (films) from fresh angle."
Recently, Nihalani was in news related to the multiple cuts in Madhur Bhandarkar's "Indu Sarkar" and refusal to certify "Lipstick Under My Burqa".
Another controversy erupted when the CBFC objected to the word "intercourse" in the Shah Rukh Khan film "When Harry Met Sejal". Besides, the decision to beep words like "cow" and "Hindu India" in a documentary on Nobel Laureate Amartya Sen also attracted criticism.