Shah was born into a Muslim family in Barabanki, Uttar Pradesh, India, as one of the three sons of Aley Mohammed Shah and his wife Farrukh Sultan. He is a descendant of a 19th-century Sayyid Afghan warlord Jan-Fishan Khan (Sayyid Muhammad Shah), who participated in the First Anglo-Afghan War and helped the British in the subsequent Indian Rebellion of 1857.

In the 1970s, Shah had met and fallen in love with Ratna Pathak, a stage and film Actress, and the daughter of Dina Pathak, a well-respected character Actress. Ratna's sister, the Actress Supriya Pathak, is married to the actor Pankaj Kapoor, who is the father of Shahid Kapoor by his first marriage. During the 70s and 80s, Naseeruddin Shah and Ratna Pathak co-starred in several films like Jaane Tu... Ya Jaane Na, Mirch Masala and The Perfect Murder. They were in a live-in relationship for many years, while Shah put together the mehr required to divorce Manara. Shah and Pathak were finally married in 1982. By his second marriage, Shah has two sons, Imaad and Vivaan, both of whom are aspiring actors. The couple lives in Mumbai with Heeba, Imaad and Vivaan.

Shah did his schooling at St. Anselm's Ajmer and St Joseph's College, Nainital. He graduated in arts from Aligarh Muslim University in 1971 and attended National School of Drama in Delhi.

In 1977, Shah, Tom Alter and Benjamin Gilani formed a theatre group called Motley Productions. Their first play was Samuel Beckett's Waiting for Godot, which was staged at the Prithvi Theatre on 29 July 1979.

Shah became active in mainstream Bollywood cinema with the 1980 film Hum Paanch. In 1982, he acted in the film Dil Aakhir Dil Hai directed by Ismail Shroff, opposite Rakhee. One of his most important films, Masoom, was released in 1983 and was shot at St Joseph's College, Nainital. His next major success in mainstream films was the 1986 multi-starrer film Karma where he acted alongside veteran Dilip Kumar. Starring roles for films such as Ijaazat (1987), Jalwa (1988) and Hero Hiralal (1989) followed. In 1988 he played opposite his wife Ratna Pathak as Inspector Ghote, the fictional detective of H. R. F. Keating's novels in the Merchant-Ivory English language film The Perfect Murder. He acted with Aditya Pancholi in films like Maalamaal (1988) and Game (1993).

He has acted in several multi-starrer Bollywood films as well, such as Ghulami (1985), Tridev (1989) and Vishwatma (1992). In 1994, he acted as the villain in Mohra, his 100th film as an actor. He forayed into Malayalam cinema the same year, through T. V. Chandran's critically well acclaimed drama Ponthan Mada. The film portrayed the irrational bonding of a feudal serf (played by Mammootty) and a colonial landlord (played by Shah). He strongly believed that the distinction between art and commercial films had largely reduced, especially with the Directors of the former also making commercial films. In 2000, his dream of playing Mahatma Gandhi was realised when he played Gandhi in Kamal Hassan's critically acclaimed Hey Ram which focused on the assassination of Gandhi from the assailant's point of view. Shah won critical acclaim by playing the role of Mohit, the drunken coach to a deaf and mute boy in Iqbal, which was written by Vipul K Rawal with Shah specially in mind. Shah was praised for his roles in the 1999 Aamir Khan-starrer Sarfarosh, where he played Gulfam Hassan – a ghazal singer-cum-terrorist mastermind — and in Neeraj Pandey's critically acclaimed A Wednesday (2008).

Shah made his Pakistani film debut in Khuda Ke Liye by Shoaib Mansoor, where he played a short cameo. His second Pakistani film Zinda Bhaag was selected as the country's official entry to the 86th Academy Awards for the Best Foreign Language Film award.

In 1988, he acted in the eponymous television series based on the life and times of Mirza Ghalib, directed by Gulzar and telecast on DD National.

In 1989, he acted as the Maratha King Shivaji in another eponymous television series Bharat Ek Khoj based on Jawaharlal Nehru's book The Discovery of India.

In mid 1990s, Shah also hosted some episodes of science magazine programme Turning Point.

In 1998, he played the role of Mahatma Gandhi in the play Mahatma Vs. Gandhi, (which looked at the Mahatma's relation with Harilal Gandhi, his first son). With this, he achieved his objective of portraying Mahatma Gandhi, a role he had auditioned for in Richard Attenborough's Gandhi. In 2000, he again portrayed the Mahatma, this time on film, in Hey Ram.

He played the villain with the dual identity of a ghazal singer and a Pakistani spy who supports terrorism in India in Sarfarosh (1999).

Shah has also starred in international projects, such as Monsoon Wedding in 2001 and a Hollywood comic book adaptation The League of Extraordinary Gentlemen in 2003 (co-starring Sean Connery), where he played the role of Captain Nemo. His portrayal of Nemo was very close to the design of the graphic novel, although his Nemo was far less manic. He worked in Vishal Bhardwaj's Indian adaptation of Shakespeare's Macbeth, titled Maqbool, in 2003, and Rajiv Rai's Asambhav opposite Arjun Rampal and Priyanka Chopra in 2004. He then went on to work in The Great New Wonderful (2005). In 2011, Shah was seen in The Dirty Picture. He acted in Anup Kurian's The Blueberry Hunt, playing a recluse growing marijuana in his forest retreat, and in Waiting, starring opposite Kalki Koechlin, both of which were released in 2016.

His directorial debut in movies, Yun Hota To Kya Hota, was released in 2006. It stars several established actors such as Konkona Sen Sharma, Paresh Rawal, Irrfan Khan, then-newcomer Ayesha Takia, his son Imaad Shah and his old friend Ravi Baswani.

He was the first of several Celebrity actors, who played the role of narrator in the popular audiobook series for kids Karadi Tales. He was the narrator in the film Paheli — the Indian entry to the 2006 Academy Awards.

In 2017, Shah returned to film, starring in Shakespearean adaption The Hungry, screened under special presentations at the Toronto International Film Festival 2017.