The committee, which said the former Norwegian prime minister would remain as a committee member, gave no reason for its decision.
However the renowned diplomat had drawn sharp criticism shortly after becoming committee chairman in 2009 for awarding the prestigious Nobel to newly elected US President Barack Obama. The move stunned the world and the recipient alike, as Obama had been in office less than nine months and the United States was waging simultaneous wars in Afghanistan and Iraq.
After six years at the helm of the high-profile committee, the 64-year-old will be replaced by the current deputy head, Kaci Kullmann Five, the organization said.
"There was broad agreement within the committee that Thorbjørn Jagland was a good chair for six years," Kullman Five told reporters, but declined to comment on the discussion.
Commentators and former Nobel laureates alike had criticized the committee's decisions under Jagland's stewardship.
Hitting back at critics after Obama's prize, Jagland said the organization wanted to praise the US leader's early vision of a world free of nuclear weapons and capture "the spirit of the times, the needs of the era".
Last year, a federal study estimated that the United States will spend $1 trillion upgrading its nuclear arsenal over the next three decades.
A year after Obama received the prize, the committee also drew Beijing's ire for handing the prize to jailed Chinese dissident Liu Xiaobo, a move that effectively put Norway-China relations on ice.
And in 2012 Jagland became the face of a body that handed the award to the increasingly unpopular European Union for its commitment to "peace and reconciliation, democracy and human rights".
"The EU is clearly not the 'champion of peace' that Alfred Nobel had in mind when he wrote his will," Archbishop Desmond Tutu wrote in an open letter with two other former laureates.
A former leader of Norway's Labour Party who has served as prime minister, foreign minister and speaker of parliament, Jagland spent much of his career trying to bolster support for Norway to join the EU. Tuesday's action raised questions of whether the Nobel committee -- which has been awarding the peace prize almost every year since 1901 - will begin to show more political colour.
Traditionally its five members are appointed by parliament but claim total independence in their decision making.
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Jagland's demotion reflects a shift into a majority of committee members nominated by right-wing parties, which won Norway's 2013 general election.
"This can be interpreted as an attempt by the rightist government to exert more political control over the committee than has been customary," Nobel historian Asle Sveen told AFP.
Others expressed more grave concerns.
"This introduces a new principle by which we associate the chair of the Nobel Committee with the new majority political colour," wrote Harald Stanghelle, editor of daily newspaper Aftenposten. "This raises the question: is the Nobel Committee as independent of a political point of view as it should be?"