About 100 temples took part in the demonstration, where performers carried statues of Taoist gods on their shoulders while others danced in larger-than-life costumes.
Taipei police said more than 10,000 people took part in the protest.
Officials have been pushing to curb the practice of burning incense sticks and paper money along with lighting firecrackers to combat pollution on the island.
But opponents of the call argue that the rituals are a crucial element of their religious traditions.
"It is very important. Our religion is upheld by the burning of incense," said a 58-year-old man surnamed Cheng, who travelled from a temple in southern Tainan city to protest.
While some devotees knelt and bowed as Taoist statutes passed by, others engaged in more violent forms of worship.
One topless man was seen with blood dripping down his face after whacking himself with a serrated stick.
But Joyce Wu, 34, was unfazed as she watched, saying it was a common ritual in rural areas of Taiwan where she grew up.
"I grew up in a rural village, how come I'm healthy and not sick? I think cars and factories cause more of a pollution problem," Wu told AFP.
The fervour erupted after rumours circulated that the government was aiming to impose a ban on the burning of incense sticks.
But the interior ministry issued a statement last week saying they have no intention of banning the practice, but are encouraging alternative measures.
"Taking into account both the spirit of tradition as well as contemporary values of environmental protection, we've called on religious groups to take appropriate measures to reduce potential pollution," it said.
Environmental groups have also warned that hazardous chemicals, such as benzene and methylbenzene, are released from burning incense and paper money.
Some temples have already taken it upon themselves to go green.
The popular Taoist Hsing Tian Kong temple in Taipei has banned incense-burning, requesting worshippers to bring their hands together to pray instead.
And another temple in central Changhua city has resorted to playing recordings of firecrackers.
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