Using data from the China Statistical Yearbook, trends in income inequality for urban and rural China are studied. According to our estimates, the overall Gini for China increased from 1980/81 to 2008. The rural Gini increased at an exponential rate of 1.2% while the urban Gini rose at a rate of 2.7%. To overcome weaknesses in the existing Gini decomposition methodology, we use the method developed by Podder and Mukhopadhaya (2002. The Changing Pattern of Sources of Income and Its Impact on Inequality: The Method and Its Application to Australia, 1975-94. Economic Record 77 (238): 242-51). In rural China, the results show that household operations are the major component of rural disposable income, while the share of wage income is also high. Income from household operations is inequality reducing, as is the case with transfers. The dominant contributors to inequality are wages and property income. Arguably, the optimal way to reduce inequality is policy-induced increases in transfers and the household operations that help the poor. In the urban sector, wage and salary income have the maximum share in total disposable income. The results show that further increases in the wage share in urban sector will increase total inequality in China.