Wastewater sludge creates a difficult environmental problem for many large cities. This study developed a three-phase innovative strategy for sludge treatment and reduction, including thermal hydrolysis, fungal fermentation, and anaerobic digestion. Increasing the temperature during the treatment from 140 to 180 °C significantly improved the sludge reduction and organic release efficiencies (p < 0.05, one-way analysis of variance (ANOVA) for the triplicate experiments at each temperature). After two cycles of thermal hydrolysis, the overall volatile solid (VS) reduction ratios of the sludge were 36.6%, 47.7%, and 58.5% for treatment at 140, 160, and 180 °C, respectively, and the total organic carbon (TOC) conversion efficiency reached 28.0%, 38.0%, and 45.1%, respectively. The highest concentrations of carbohydrates and proteins were obtained at 160 °C in sludge liquor, whereas the amount of humic substances significantly increased for the treatment at 180 °C (p < 0.05, one-way ANOVA for the triplicate experiments at each temperature) due to the Maillard reaction. Fungal fermentation of the hydrolyzed sludge liquor with Aspergillus niger converted the waste organics to valuable fiber materials. The biomass concentration of fungal hyphae reached 1.30 and 1.27 g·L−1 in the liquor of sludge treated at 140 and 160 °C, corresponding to organic conversion ratios of 24.6% and 24.0%, respectively. The fungal hyphae produced from the sludge liquor can be readily used for making papers or similar value-added fibrous products. The paper sheets made of hyphae fibers had a dense structure and strong strength with a tensile strength of 10.75 N·m·g−1. Combining fungal fermentation and anaerobic digestion, the overall organic utilization efficiency can exceed 75% for the liquor of sludge treated at 160 °C.