AbstractEcosystems are increasingly prone to climate extremes, such as drought, with long‐lasting effects on both plant and soil communities and, subsequently, on carbon (C) cycling. However, recent studies underlined the strong variability in ecosystem's response to droughts, raising the issue of nonlinear responses in plant and soil communities. The conundrum is what causes ecosystems to shift in response to drought. Here, we investigated the response of plant and soil fungi to drought of different intensities using a water table gradient in peatlands—a major C sink ecosystem. Using moving window structural equation models, we show that substantial changes in ecosystem respiration, plant and soil fungal communities occurred when the water level fell below a tipping point of −24 cm. As a corollary, ecosystem respiration was the greatest when graminoids and saprotrophic fungi became prevalent as a response to the extreme drought. Graminoids indirectly influenced fungal functional composition and soil enzyme activities through their direct effect on dissolved organic matter quality, while saprotrophic fungi directly influenced soil enzyme activities. In turn, increasing enzyme activities promoted ecosystem respiration. We show that functional transitions in ecosystem respiration critically depend on the degree of response of graminoids and saprotrophic fungi to drought. Our results represent a major advance in understanding the nonlinear nature of ecosystem properties to drought and pave the way towards a truly mechanistic understanding of the effects of drought on ecosystem processes.