Mr Taseer, a senior member of the ruling Pakistan People's Party (PPP), was shot in a popular shopping district of the city by a member of his own security detail.
He was taken to hospital where he died from his injuries.
His alleged assassin has been arrested.
Salman Taseer was politically close to the president
Mr Taseer had recently spoken out against the country's blasphemy law, prompting protests by Islamists.
The BBC's Aleem Maqbool, in Islamabad, says Mr Taseer was one of Pakistan's most important political figures and his death will further add to instability in the country.
The PPP-led government is facing a crisis that erupted after a coalition partner quit.
(Analysis
M Ilyas Khan
BBC News, Islamabad
The assassination of Salman Taseer once again highlights Pakistan's unending troubles. He was a high-profile leader of the PPP, and was governor of the country's largest province, Punjab. His death has left the country in shock at a time when it faces an imminent political crisis.
On the face of it, the assassination appears to be an individual act of a police guard in Mr Taseer's security detail. The guard has reportedly said he killed him because Mr Taseer publicly opposed the blasphemy law.
But the timing of the assassination holds deeper implications for the government, which is struggling to shore up political support to maintain a majority in the parliament. Whether it gets this support will be decided by one of two major political forces of Punjab - the opposition PML-N and the PML-Q parties. The assassination has the potential to upset these negotiations.)
A witness at the scene said Mr Taseer was shot as he was getting out of his car at Kohsar Market, a shopping centre in Islamabad popular with Westerners and wealthy Pakistanis.
"The governor fell down and the man who fired at him threw down his gun and raised both hands," Ali Imran told Reuters news agency.
Interior Minister Rehman Malik said: "The police guard who killed him says he did this because Mr Taseer recently defended the proposed amendments to the blasphemy law.
"This is what he told the police after surrendering himself.
"But we are investigating to find out whether it was his individual act or whether someone else was also behind it."
Prime Minister Yousuf Raza Gilani condemned the assassination and ordered an immediate inquiry into the killing.
The PPP has said it will observe two weeks of mourning over the assassination of Mr Taseer.
Pakistan has seen a wave of attacks by Islamists in recent years, including the assassination of former Prime Minister Benazir Bhutto.
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