Homnath Sigdel, 44, was taken into custody on Tuesday for “sharing indecent photos that targeted the prime minister”, senior police officer Narendra Prasad Uprety told AFP.
The offending image appeared on a Facebook group earlier this month and has been shared more than 2,500 times.
Police said Sigdel had also posted a second photo of Oli’s head on a naked human body.
Sigdel could face up to five years in jail and a 100,000 rupee ($900) fine if found guilty under a provision in the Electronic Transactions Act.
The arrest comes days after Nepal introduced a new criminal code that includes draconian laws that activists have warned could be used to silence critics of the government.
The Communist-led government headed by Oli has shown increasing intolerance of dissent since it took power at the beginning of the year.
In June it became embroiled in a standoff with a popular activist doctor who was on hunger strike to protest against political interference in the medical sector.
In 2016, a Canadian working in Nepal was deported over a series of tweets deemed to “incite conflict” related to the country’s constitution.
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