The control character produced by Ctrl+Z is \032 in octal. This can be deleted by tr:
tr -d '\032' <file >newfile
This deletes the characters anywhere in the file and creates a new file called newfile with the modified contents.
Your sed command does not work as the expression ^Z would match a Z character at the start of the line. The ^ anchors the rest of the expression at the start of the line.