Yup that is not going to work too well. Say the router was trying to figure out how to send data to a new ip such as 192.168.0.100. Which interface will he send the ARP to.
I suppose you could make this work with proxy arp and doing strange stuff like sending out arp on 2 interfaces.
I suspect you will quickly get duplicate IP addresses in a configuration like this.
If you question is why did the router not change the IP for the LAN that I have no clue I normally manually select the lan addresses when there is any strangeness to the configuration.
As you said i changed the LAN IP manually to 192.168.1.1 and now its all working how it should be. before when i try to ping the Gateway IP there was many packet loss, even the ping time was showing above 2000+ ms. After changing Lan Ip manually, now there no packet loss and ping time is less than 10ms.