Killing of Salman Taseer in the capital was the most high-profile assassination of a political figure in Pakistan since the slaying of former prime minister Benazir Bhutto in 2007.
Pakistani Prime Minister Yousuf Raza Gilani condemned the assassination of his ally and ordered an immediate inquiry into the killing.
Interior Minister Reham Malik said Mr Taseer, 56, had been shot because of his high-profile opposition to the blasphemy laws.
The assassin was a member of governor Mr Taseer's security team, Mr Malik said.
"He confessed that he killed the governor himself because he had called the blasphemy law a black law," Mr Malik said.
Mr Taseer was a member of Bhutto's Pakistan People's Party and a close associate of President Asif Ali Zardari, her widower.
He had spoken out against the blasphemy law in recent days. Islamists have defended the controversial law.
Police official Mohammad Iftikhar said Mr Taseer was gunned down after arriving at Islamabad's Khosar Market, a shopping centre not far from his home and popular with Westerners and wealthy Pakistanis.
Local administration chief Amir Ahmad Ali said Mr Taseer died in hospital of his wounds.
Five other people were wounded as other security personnel responded to the attack.
Another police official, Hasan Iqbal, said a pair of witnesses told the police that as the governor was leaving his vehicle, a man from his security squad fired two shots at him. Mr Taseer then fell, while other police officials fired on the attacker. It was unclear if the attacker was wounded.
"I was in the market. I heard the gunfire and hit the ground," said Shaukat, 28, a labourer.
"While running for shelter I saw a man in uniform being grabbed by police. Later on, police officials said he was the attacker."
Police and anti-terror forces surrounded the area and the market closed after the attack. A silver Toyota with a flat wheel was parked on one side. Blood was smeared on the road in two places.
Mr Taseer was one of the most moderate political voices in the ruling PPP, which this week slumped into a political crisis when its junior coalition partner walked out of the federal government.
As well as the blasphemy laws, he was outspoken against the Taliban and other Islamist militants hunkered down in the country's northwest, and which have made increasing inroads into Punjab in recent years.
Mr Taseer made his money as a chartered accountant and had set up consultancy firms and a brokerage house before going into politics.
He was minister for industry and production under former military ruler Pervez Musharraf from 2007 to 2008.
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