Not sure if I understand the question correctly but should you return only a single value. Something like
CREATE OR REPLACE FUNCTION max_emp_id_select() RETURNS integer AS
$BODY$
DECLARE
p_emp_id integer;
BEGIN
SELECT COALESCE(max(emp_id),0)
INTO p_emp_id
FROM Employee;
RETURN p_emp_id + 1;
END;
$BODY$
LANGUAGE plpgsql;
Sorry for any typos. It's been years since I last used pgplsql...
ADDED
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Have a try with
UPDATE employee1
SET emp_id = max_emp_id_select()
WHERE ...