Abstract Water use efficiency (WUE) is central to the global cycles of water and carbon. However, whether increasing tree diversity in forests can increase WUE remains poorly understood because the variation in WUE may result from multiple mechanisms acting concurrently. Disentangling their relative importance represents a major challenge. Here, we conducted a forest biodiversity experiment in subtropical China to assess the effects of neighbouring tree diversity on the foliar WUE of Cunninghamia lanceolata, a widespread tree plantation species in China. We measured foliar δ13C as a proxy for the change in intrinsic WUE. To disentangle the relative importance of water and nutrient‐mediated mechanisms in altering WUE, we determined foliar nutrient concentrations and foliar δ18O. Foliar δ18O was used as a surrogate for stomatal conductance and is known to be related to plant water use. Foliar WUE of focal trees increased with specific root length and leaf nitrogen content dissimilarities between focal trees and neighbours. The positive neighbourhood dissimilarity effect on foliar WUE was stronger under a more shaded neighbourhood. Foliar P concentration increased with neighbourhood specific root length dissimilarity. However, neither neighbourhood trait dissimilarities nor species richness significantly affect foliar δ18O. Results from structural equation model suggested that neighbourhood dissimilarity in specific root length indirectly enhanced foliar WUE and tree growth of focal trees via increasing foliar P concentration. Synthesis. Our results demonstrate the potential role of neighbourhood trait dissimilarity in modulating tree WUE in species‐rich communities. Our finding implies that the functional diversity of tree species at the local neighbourhood level has a fundamental ability to control water and nutrient cycles in forests.