46-year-old Nadella, who takes over as the third CEO of the Redmond-based firm, is the first Indian to head the world's largest software firm in its 38-year history, ending months of speculation as to who would succeed the retiring Steve Balmer.
Nadella, along with Google's Sundar Pichai, were the contenders for the top job.
A cricket enthusiast, Hyderabad-born Nadella, who had joined Microsoft in 1992, previously served as the Executive Vice President of Cloud and Enterprise Group.
John Thompson, who is currently lead independent director, will succeed Microsoft founder Bill Gates as Chairman.
Gates will don a new hat of technology adviser and retain a seat on the board, the company said in a statement.
"As Satya Nadella becomes the third CEO of Microsoft, he brings a relentless drive for innovation and a spirit of collaboration to this new role," Microsoft said in a statement, announcing Nadella's appointment.
Reacting to his appointment, Nadella said, "Microsoft is one of those rare companies to have truly revolutionized the world through technology, and I couldn't be more honored to have been chosen to lead the company."
In an email to employees on first day as CEO, Nadella paraphrased a quote from Oscar Wilde--"We need to believe in the impossible and remove the improbable".
"We are the only ones who can harness who can harness power of software and deliver it through devices and services that truly empowers every individual and every organisation," he said.
Praising Nadella as a "proven leader" with hard-core engineering skills, business vision and the ability to bring people together, Gates said, "During this time of transformation, there is no better person to lead Microsoft than Satya Nadella."
Nadella takes on as the CEO at a time when the company is facing a slow erosion of its PC-centric Windows and Office businesses and is looking at refuelling its mobile ambitions with the takeover of Finnish handset maker Nokia.
Before joining Microsoft. Nadella was a member of the technology staff at Sun Microsystems.
Nadella attributed his rise to the top to cricket.
"I think playiong cricket taught me more about working in teams and leadership that has stayed with me throughout my career," he said shortly after was named for the top post.