The Supreme Court asked the government to go back to the selection committee.
Verma has been reinstated but cannot take policy decisions, the top court said in its verdict.
The apex court also said that any further decision against Verma would be taken by the high-powered committee which selects and appoints the CBI Director.
It said the high-powered committee will take its decision on the basis of the findings of the CVC inquiry. It said the meeting of the committee should be convened within a week.
The court also set aside the Centre's decision to appoint senior IPS officer M Nageswara Rao, who was the joint director, as the interim chief of the agency.
The bench had reserved the verdict on December 6 last year after hearing arguments of Verma, the union government, Central Vigilance Commission (CVC), NGO Common Cause and Congress leader Mallikarjun Kharge and others who were the party in the case.
The CVC had told the apex court that "extraordinary situations sometimes need extraordinary remedies."
CJI Ranjan Gogoi had earlier raised questions over the timing of the order and asked why the government took immediate steps to divest Verma of his powers without consulting the selection committee.
Attorney General KK Venugopal appearing for the DoPT had told the bench that the government was well within its jurisdiction to send both officers (Verma and CBI Special Director Rakesh Asthana) on leave by divesting them of their powers.
In October, Alok Verma and Rakesh Asthana were asked to go on leave by the government in the midst of an internal rift over bribery allegations against the latter.
The feud between Verma and Asthana was marked by allegations and counter-allegations of corruption and interference in high-profile cases.
A bench headed by Chief Justice of India Ranjan Gogoi delivered the verdict