Changes in the hydrological cycle, as predicted and currently observed, are expected to significantly impact the water and carbon balance of water-limited forest ecosystems. However, differences in the water-sensitivity of component processes make carbon balance predictions challenging. To examine responses of ecosystem components to water limitations, we conducted a study of tree, soil and ecosystem-level processes in a young ponderosa pine stand under natural summer drought (control) and increased soil water conditions (watered). Weekly-averaged tree transpiration (Ttree), gross ecosystem photosynthesis (GPP) and soil CO2 efflux (Rstree; nearby trees) were related with soil water content (SWC; polynomial form: TtreeR2 = 0.98 and RstreeR2 = 0.91, logarithmic form: GPP R2 = 0.86) and declined rapidly when relative extractable soil water (REW) was <50%. The sensitivity of daily variations in canopy conductance (Gs) to vapor pressure deficit was affected by SWC (R2 = 0.97; logarithmic function), decreasing at REW <50%. Watering maintained REW at about 70% in July and August but positively affected tree carbon and water dynamics only at the end of summer when fluxes in the control treatment were strongly water-limited. A tight coupling of above- and belowground fluxes became apparent. In the control treatment, root-rhizosphere respiration (Rr) decreased along with GPP and Ttree (R2 = 0.58) as drought progressed, while watering maintained Rr, Ttree and Gs at a significantly higher level than those of the unwatered trees in late summer. In contrast, microbial respiration responded instantaneously and strongly to the watering compared to the control treatment. The net effect was that increased soil water availability during the typical dry growing season has a negative effect on the short-term seasonal ecosystem C balance due to a larger increase in decomposition than photosynthesis. However, longer-term effects remain uncertain. In summary, our study highlights that understanding the dissimilar response of tree dynamics and soil decomposition to water availability is a key component in predicting future C sequestration in water-limited forest ecosystems.