The ancient town in southern Yunnan province, beneath Cang Mountain and near Erhai Lake, was once dubbed China's "hidden gem", for its pristine scenery and the traditional ways of its ethnic Bai inhabitants.

Nearby Shuanglang, a 1000-year-old fishing village, became a magnet for young Chinese seeking an alternative life, as hundreds of guest houses, bars and restaurants spread around Erhai's shore.

The music and arts scene flourished. A school was set up to educate their children outside the Chinese education system.

But the eco-bohemian dream came crashing down this week, as local authorities began closing hundreds of businesses in Shuanglang.

Up to 2000 guest houses and restaurants along a 130-kilometre stretch around the lake face closure for a year for failing spot inspections of their septic tanks.

Erhai Lake has become heavily polluted, and the authorities blame raw sewage being pumped into its waters by the fashionable new buildings.

Guest house owners who have spoken to Fairfax Media are stunned that just a day's notice was given before the closures, which are designed to allow the town to build a new sewage system. Even McDonalds has been shut, they say.

All farming land - which includes many of the most scenic lakeside hotels - will be reclaimed by the government.

Mei Zhang is the author of Travels Through Dali With a Leg of Ham, her 2016 memoir of growing up in Dali. She watched its more recent transformation into a cultural community dubbed "Dali-fornia" by some.

She told Fairfax Media the forced closures have upset many of her friends, whose livelihoods are dependent on the lakeside guesthouses.

"From an environmental point of view, it is great they are going to take action, but as a human being, this is everything they own."

Ms Zhang, an eco-tourism pioneer in China, said the "new Dali people" had brought good and bad to the town.

It was the arrival in 2004 of Ye Fu, a famous Chinese writer, that began the migration. "A lot of young Chinese literary people followed him," she says. Next came the artists and film-makers.

"Then came more young urbanites, yuppies, couples with babies who wanted a new life. They brought modern tastes in architecture and services, and they all wanted to be on the lake front to get that stunning view," she said.

The problem was, lakefront land was traditionally farming land that wasn't for sale. The new arrivals signed long-term leases for a cheap price. When the Bai villagers saw the huge leap in land value as tourism boomed, resentment grew, says Ms Zhang.

Town regulations didn't keep up. "It was anarchy and you had to fend for yourself," she said, explaining why so many new arrivals have found themselves in breach of the rules.

Dali's Bai population is 1 million. It was reported last week that 24 million people visited Dali in 2016, she said.

"That is an extraordinary number. I can't imagine the impact on waste and sewerage," she said.

With no tourism income, some smog refugees will be forced to leave. For the creative community, the disillusionment may have already set in before the shutdowns.

"Some people have looked at Dali's explosion and said this is not the utopia they thought it was," she said.

A Dali native, now living in California, she hopes Dali's cultural spirit survives.

In the past four years, the number of inns in Shuanglang alone tripled to 380.

The town's environment protection officer was jailed for four years for accepting bribes last year, and blamed for neglect of duty, according to local media reports.

The guest house owners agreed the lake needs to be cleaned up, but are upset that no offer of compensation has been made. Restaurants say they will be forced to lay off the local Bai villagers they employ.

Business owners estimate Dali will lose 5 billion Chinese yuan ($960 million) from its economy over the next two years.

One local hotel owner said he employed 20 staff, and had a wages bill of 60,000 yuan a month. He estimates he will lose 300,000 yuan this month alone.

Greenpeace's water campaigner Tingting Deng said Yunnan was "a beautiful place", but Erhai Lake had become heavily polluted with nitrogen and phosphorous, causing frequent algae blooms.

In the past, air pollution had been the focus of the Chinese government's environmental clean-up efforts, but this was changing, and since 2015, local governments had been told to take responsibility for improving water quality, she said.