Reigning world champion takes 13-point advantage into the free skate with Kevin Aymoz third after a thrilling short program in Turin
Reigning world champion Chen landed three clean jumping passes, including two quadruples, in a composed performance.
Double Olympic gold medallist Hanyu started strongly but stepped out of his quadruple toe loop and did not go through with the second part of the combination jump.
If Chen was feeling the pressure as one of the two heavy favourites in Turin, you would not have guessed it as he landed a quad Lutz, triple Axel and quad toe loop, triple toe loop combination with apparent ease.
The display earned the American a season-high score of 110.38, just 0.15 shy of Hanyu's world record set at last year's Rostelecom Cup.
Japanese fan-favourite Hanyu opened with a smooth quad Salchow followed by a triple Axel.
But he stepped out of his final quad toe loop and was not able to add the triple toe to leave him some way behind Chen with a score of 97.43.
Chen was largely happy with what he was able to deliver at the Palavela, telling the media: "I'm pretty satisfied. I'm happy with the score. I'm glad I was able to lay down the jumps."
Asked how close he felt his skate was to perfection, the American added: "Close-ish. Perfection is something that I don't think anyone can really obtain.
"But I'm happy with the Lutz. The second two jumps were a little shaky. I would definitely like to make those a little lighter, since I know I'm capable of doing that. And the program I think I can definitely start feeling the music better.
"Overall though, I'm pretty satisfied with the program and I'll sit down and watch the program and see what I can improve on."
Kevin Aymoz was third after refusing to let a technical problem with his music at the beginning of his program faze him.
As he prepared to skate to Prince's 'The Question of U', the wrong music started up twice.
But the mishap seemed to fire up the French skater and he delivered a season's best score of 96.71.
The 21-year-old cleanly landed a quadruple toe loop, triple Lutz, triple toe combination and triple Axel in an entertaining skate.
The score announcement prompted a jubilant reaction from Aymoz and his coach in the 'Kiss and Cry'.
Double Olympic champion Hanyu was competing without the usual support from his coaches at the boards.
Hanyu revealed afterwards that jumping coach Ghislain Briand was supposed to be travelling to Turin instead of regular coach Brian Orser but had some issues getting to the competition.
However, he said after his performance: "I don't feel any difficulties without my coaches here."
Hanyu's short program is a tribute to one of his idols, Johnny Weir, who skated at the Torino 2006 Winter Olympics.
He added: "To tell the truth, this program was performed by Johnny Weir in Turin in 2006. I wanted to do a great job with it here, so it was pretty disappointing."
The skater, who turns 25 on Saturday, is hoping to come back strongly in the free skate.
"I watched the points that Nathan got, so I wanted to skate my best," said Hanyu. "But that didn't happen this time. I want to make it a good experience going into the free skate. I have a good goal to set for the free skate now."
The Turin competition marks the first time Chen and Hanyu have gone head-to-head since the World Championships in Saitama in March when the American took gold ahead of the Japanese.
In his first Grand Prix Final, Aymoz did incredibly well to put the frustration of a false start to his program behind him.
He said, "Just before the program when the music didn't start... I felt so lonely, like the only one in the world, one million eyes on me
"At this moment I said to myself, 'Don't cry or leave the ice now.' After the music started I totally forgot what happened."
Just over two points separate the top three after the pairs' short program, setting up a tantalising free skate on Friday.
The pair are keen to improve in the free skate with Sui saying: "We weren’t very satisfied with our performance. The elements were tight and we made some mistakes. We want to learn from our experience and do our best tomorrow."
Two young Russian pairs delivered clean performances to claim the second and third spots and put themselves firmly in the medal hunt.
Aleksandra Boikova and Dmitrii Kozlovskii, skating to 'My Way', scored 76.65 to go second after successfully executing side-by-side triple Salchows, a triple twist lift and a triple flip throw.
Compatriots Daria Pavliuchenko and Denis Khodykin were close behind in third with a score of 75.16.