Pollution of high-altitude lake basins by agriculture and rural activities, and the control of this pollution, have received increasing attention from academic research and government policy in China. Series of restrictions and regulations have been implemented to protect the surface water quality. These restrictions and regulations have greatly impacted and transformed the agricultural systems and rural livelihoods surrounding these lake basins. Using Erhai Lake basin in Yunnan Province as a case study, three main challenges were identified for concurrently decreasing pollution in the lake and increasing farmer income. It is contended that scientifically-sound environmental protection policies and agricultural green development practices are key to reversing the current situation. This will help to protect the lake from pollution while smallholder farmers will be able to produce healthy food in an environmentally sustainable manner, and with a fair remuneration for all the services farmers provide to the society.