Abstract With the great successes in improving rural electrification and reducing poverty, China's small hydropower (SHP) development is expected to provide a good example for other developing countries. However, recently, nearly all new SHP development plans have been halted, and many plants have been urged to shut down or even be removed. The SHP industry in China is now in a dilemma. This paper presents a review of the status of SHP development in China and explores the challenges troubling this industry. It was revealed that SHP resources in many provinces have been intensively exploited, with an exploration rate over 0.80, while untapped resources are primarily located in remote western provinces, such as ecologically fragile Tibet. This intensive and disordered SHP development has caused serious dewatering of rivers and affected local agricultural and household water access, which arouses fierce controversy. Moreover, the role of SHP has been gradually weakened by the extension of power grids and diversified electricity sources. Therefore, the transition and upgrade of the SHP industry has become critical to enhance its sustainable development and to provide a solid example for the world. A divergence management strategy for SHP should be adopted to achieve low-impact development, as opposed to blind large-scale development or rigidly discontinuing all projects. Future transition strategies are proposed in this paper that include delicate management of existing plants and construction of new plants with higher standards, as well as pathways for the development benefits to be shared by a wider range of local residents.