Wood remains a cornerstone material in construction and outdoor applications, yet its durability is continually compromised by fungal decay and insect infestation. Increasing regulatory restrictions on conventional wood preservatives and growing sustainability demands have intensified interest in bio-based alternatives. Among these, essential oils exhibit strong antifungal and insect-repellent activity but suffer from high volatility, leaching, and limited durability under moisture exposure. This review examines recent advances in chitosan nanoparticle-based encapsulation of essential oils as a strategy to overcome these limitations and enable more sustainable and environmentally responsible wood protection systems. The review synthesizes current knowledge on nanoparticle synthesis routes, physicochemical properties, bioactive delivery mechanisms, antifungal and anti-termite performance, and behavior under moisture and weathering conditions, alongside sustainability and regulatory considerations. The reviewed literature demonstrates that chitosan nanoparticles enhance essential oil retention, stability, and controlled release, leading to improved resistance against biological deterioration compared with unencapsulated formulations. In addition to performance benefits, these nano-enabled systems align with circular bioeconomy principles by utilizing renewable and waste-derived feedstocks while avoiding heavy metals and persistent synthetic biocides. Despite promising laboratory results, challenges remain related to long-term field performance, scalability, and environmental fate. Overall, chitosan–essential oil nano-formulations represent a versatile platform for next-generation, low-hazard wood protection, offering a promising pathway toward sustainable and durable wood preservation technologies.