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 promoting type I IFN induction to limit 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 deISGylation 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.IMPORTANCEThe role of protein ISGylation in regulating host cellular processes has been studied extensively; however, how ISG15 conjugation influences the activity of viral proteins, particularly coronaviral proteins, is largely unknown. Our study uncovered that the nucleocapsid (N) protein of SARS-CoV-2 is ISGylated by the HERC5 ISGylation machinery and that this modification impedes the functional assembly of N into oligomers ultimately inhibiting viral RNA synthesis. This antiviral restriction mechanism is antagonized by the PLpro deISGylation activity of SARS-CoV-2 NSP3. This study deepens our understanding of SARS-CoV-2 protein regulation by posttranslational modifications and may open new avenues for designing antiviral strategies for COVID-19.