Threshold nonlinearities in the relationship between island area and species richness can result in dramatic declines in richness with a seemingly small decline in area near the threshold. What is not known, is whether threshold declines in richness are also accompanied by nonlinear changes in functional trait space and non-random shifts of trait group composition in response to declining area. Plant species richness was recorded, and four functional diversity (FD) indices calculated based on 12 traits for 76 tree species in 5,082 plots (5 × 5 m) on 29 islands in the Thousand Island Lake region, Zhejiang, China. We tested for threshold nonlinearities in richness and FD relationships using segmented regression, with randomized resampling using a null model to account for potential sampling artefacts. We clustered tree species into trait groupings based on trait dissimilarity, and used multinomial segmented models to test whether threshold area effects on FD were associated with shifts in trait group composition. Species richness and three of the four FD indices showed significant threshold nonlinearities with declining island area below a threshold of ca 1.16–6.88 ha. K-means clustering identified two trait groups, reflecting species at the ‘fast’ versus ’slow’ ends of the trait spectrum. Significant area thresholds in trait group composition were driven by increasing relative richness, but decreasing relative abundance, of species with resource-conservation traits on islands below the threshold. Synthesis. We found a threshold collapse in richness on islands below c. 1 ha, resulting in a significant decrease in functional trait space (functional richness) and an increase in the degree of niche differentiation among species in the community (functional divergence) on small islands. Threshold effects were associated with non-random re-assembly of trait group composition, favouring the relative richness of species at the ‘slow’ resource-conservation end of the trait spectrum, but the relative abundance of a few species with ‘fast’ resource-acquisition traits. These results suggest that disturbance-driven dynamics potentially drive a functional shift in the ecosystem state at a critical threshold. We show that a minimum critical habitat area is required to maintain functional diversity in woody plant communities.