The Nikkei Manufacturing Purchasing Managers' Index, compiled by IHS Markit, rose to 54.7 in December from November's 52.6, marking its fifth straight month above the 50 level that separates expansion from contraction.
"India's goods-producing economy advanced on its recovery path, with operating conditions improving at the strongest pace since December 2012," said Aashna Dodhia, an economist at IHS Markit.
"Strong business performance was underpinned by the fastest expansions in output and new orders since December 2012 and October 2016, respectively. Anecdotal evidence pointed to stronger market demand from home and international markets."
The country's manufacturing sector witnessed higher payroll figures in December while the rate of job creation rose to its highest since August 2012.
The latest survey showed the new orders sub-index, a proxy for domestic demand, also rose to 56.8 in December, the highest since October 2016.
Foreign demand also expanded at its quickest pace since June.
"Challenges remain as the economy adjusts to recent shocks, but the overall upturn was robust compared to the trend observed for the survey history. This outlook was shared by the manufacturing community as sentiment picked-up to the strongest in three months amid expected improvements in market conditions over the next 12 months," Ms Dodhia added.
At the same time, stronger demand allowed firms to raise prices at the fastest pace in 10 months to make up for rising input costs, suggesting overall inflation could remain above the central bank's medium-term target of 4.0 per cent in the coming month.
Retail inflation in November breached the RBI's medium-term target of 4 per cent, which could put pressure on it to raise policy rates in the coming months.
Minutes from the RBI's December meeting show bank members are becoming increasingly concerned about inflation.