Interferon (IFN)-stimulated gene 15 (ISG15), a ubiquitin-like protein, is covalently conjugated to host (immune) proteins such as MDA5 and IRF3 in a process called ISGylation, thereby limiting the replication of Severe acute respiratory syndrome coronavirus 2 (SARS-CoV-2). However, whether SARS-CoV-2 proteins can be directly targeted for ISGylation remains elusive. In this study, we identified the nucleocapsid (N) protein of SARS-CoV-2 as a major substrate of ISGylation catalyzed by the host E3 ligase HERC5; however, N ISGylation is readily removed through de-ISGylation by the papain-like protease (PLpro) activity of NSP3. Mass spectrometry analysis identified that the N protein undergoes ISGylation at four lysine residues (K266, K355, K387 and K388), and mutational analysis of these sites in the context of a SARS-CoV-2 replicon (N-4KR) abolished N ISGylation and alleviated ISGylation-mediated inhibition of viral RNA synthesis. Furthermore, our results indicated that HERC5 targets preferentially phosphorylated N protein for ISGylation to regulate its oligomeric assembly. These findings reveal a novel mechanism by which the host ISGylation machinery directly targets SARS-CoV-2 proteins to restrict viral replication and illuminate how an intricate interplay of host (HERC5) and viral (PLpro) enzymes coordinates viral protein ISGylation and thereby regulates virus replication.