Nitrogen is a vital nutrient for rice growth; however, its inefficient use often results in nutrient loss, environmental degradation, and the emission of greenhouse gases. In this study, a rice paddy simulation was conducted under different water levels (1–4 cm), incorporating a comprehensive analysis of nitrogen dynamics, environmental factors, and microbial communities to evaluate the impact of water levels on nitrogen concentrations and microbial composition. The results indicated that the water level had a greater impact on nitrogen concentrations in surface water than in soil water. Compared to low water level conditions (1 cm), the average concentrations of ammonium nitrogen, nitrate nitrogen, and nitrite nitrogen in surface water under 2–4 cm water levels decreased by approximately 53.8%, 36.7%, and 78.9%, respectively. Water levels also influenced the microbial composition and nitrogen cycling in paddy soil, with lower water levels promoting aerobic processes such as nitrification, while higher water levels facilitated anaerobic processes such as denitrification and dissimilatory nitrate reduction to ammonium. Correspondingly, microbial composition shifted, with aerobic bacteria predominating in shallow water conditions and anaerobic bacteria flourishing under deeper water. These findings suggest that optimized water management, particularly through shallow irrigation, may mitigate nitrogen loss and improve nitrogen use efficiency. Nevertheless, additional field studies are necessary to validate these results and explore their interaction with other agricultural practices.