I work in NJ on contract and live in NJ but my employer is in NC. I pay NC taxes and not paying NJ taxes.

Is it OK?

Negative.

Since you live and work in NJ, you should be paying NJ taxes, NOT NC taxes.

NJ will eventually figure out that you are a NJ resident and come looking for their "pound of flesh". That could be a rather unpleasant experience.

My employer told me that... since I am on H1 and not sure how long the contract is going to be in NJ... so did taxes in NC. We are going to change it now to NJ. As I got W2 for NC in 2006, is there any issue with 2006 filing?

In my opinion, you need to file NJ taxes and amend your NC tax return to get ALL of the withheld NC taxes back.

NJ has a legal claim to the tax you owe them; NC does NOT, since you did NOT work or live in NC.