The company also said that co-founder Bill Gates would step down as chairman in a historic shift at one of the world's most important technology companies.
Nadella, 46, who joined Microsoft in 1992, is executive vice president of Microsoft's Cloud and Enterprise group, working primarily with business customers. Although his division posted more than $20 billion in revenue last year, making it larger than most other tech companies, analysts have said he faces a huge challenge in assuming control of the sprawling Microsoft business.
Investors reacted positively Tuesday morning, sending Microsoft's stock up 18 cents or .49% to $36.66 in early trading.
By selecting an insider after a search that lasted more than five months, the company signaled that it likely won't pursue the kind of radical makeover that some on Wall Street had wanted.
Nadella is a well-respected executive dubbed by many analysts as a "safe" choice.
On the Microsoft website, the company said Nadella "brings a relentless drive for innovation and a spirit of collaboration to his new role. He joined Microsoft 22 years ago because he saw how clearly Microsoft empowers people to do magical things and ultimately make the world a better place."
On the site, Nadella said that many companies "aspire to change the world. But very few have all the elements required: talent, resources and perseverance. Microsoft has proven that it has all three in abundance."
"During this time of transformation, there is no better person to lead Microsoft than Satya Nadella," Gates said in a news release. "Satya is a proven leader with hard-core engineering skills, business vision and the ability to bring people together. His vision for how technology will be used and experienced around the world is exactly what Microsoft needs as the company enters its next chapter of expanded product innovation and growth."
In the news release, the company said Gates will "assume a new role on the board as founder and technology advisor, and will devote more time to the company, supporting Nadella in shaping technology and product direction."
John Thompson, who oversaw the search for a new CEO, will become the new chair.
"Satya is clearly the best person to lead Microsoft, and he has the unanimous support of our board," Thompson said in the news release. "The board took the thoughtful approach that our shareholders, customers, partners and employees expected and deserved."