The actor, best known for his role as Joe Wicks in EastEnders, was cast as PE teacher Jez Diamond last month. However, Nicholls was let go just three days into filming, The Mirror reports.
The 32-year-old's contract was terminated after he was allegedly reprimanded for arriving on set late twice. According to the paper, Nicholls was badly affected following the death of his grandfather.
"Paul is a lovely guy but he is in a dark place at the moment," a source said. "We let him go because it wasn't working out, and hopefully some time off now will give Paul the opportunity to sort himself out."
Another show insider commented: "His behaviour on set was very odd. People felt uncomfortable around him. It was clear Paul was having some personal problems."
Nicholls, who spoke about his drink and drug battle in 2008, will be replaced by former The Bill star Alex Walkinshaw, who is thought to be reshooting scenes this week.
A BBC spokesperson added: "Paul Nicholls has left Waterloo Road. The show producers Shed Productions said the actor's decision was for personal reasons, following a recent family bereavement."
Nicholls appeared alongside Billie Piper in the final series of ITV2's Secret Diary of a Call Girl earlier this year.
> Paul Nicholls Picture Special
> More Waterloo Road news and spoilers