We present a high-resolution photoluminescence study of Er-doped SiO2 sensitized with Si nanocrystals (Si NCs). Emission bands originating from recombination of excitons confined in Si NCs, internal transitions within the 4f -electron core of Er3+ ions, and a band centered at λ≈1200 nm have been identified. Their kinetics were investigated in detail. Based on these measurements, we present a comprehensive model for energy-transfer mechanisms responsible for light generation in this system. A unique picture of energy flow between the two subsystems was developed, yielding truly microscopic information on the sensitization effect and its limitations. In particular, we show that most of the Er3+ ions available in the system are participating in the energy exchange. The long-standing problem of apparent loss of optical activity in the majority of Er dopants upon sensitization with Si NCs is clarified and assigned to the appearance of a very efficient energy exchange mechanism between Si NCs and Er3+ ions. Application potential of SiO2: Er, sensitized by Si NCs, was discussed in view of the newly acquired microscopic insight. © 2008 The American Physical Society.