During her childhood, Polley's siblings teased her because she bore no physical resemblance to Michael. Polley discovered as an adult that her biological father was actually Harry Gulkin, with whom her mother had an affair (as chronicled in Polley's film Stories We Tell). Gulkin, the son of Russian Jewish immigrants, is a Quebec-born film Producer who produced the 1975 Canadian film Lies My Father Told Me, and had met Diane after attending a play in which she acted in Montreal in 1978.

That same year, she played one of the lead characters in Terry Gilliam's The Adventures of Baron Munchausen. Polley burst into the public eye the following year, 1990, as Sara Stanley on the popular CBC television series Road to Avonlea. The series made her famous and financially independent, and she was hailed as "Canada's Sweetheart" by the popular press.

The show was picked up by the Disney Channel for distribution in the United States. At the age of 12 (around 1991), Polley attended an awards ceremony while wearing a peace sign to protest the first Gulf War. Disney executives asked her to remove it, and she refused. This soured her relationship with Disney, though she continued on Road to Avonlea until 1994. The show ran until 1996, although Polley did return as Sara Stanley for an episode in 1995 and for the series finale.

In 1995, she lost two back teeth after being struck by a riot police officer during a protest against the Provincial Progressive Conservative government of Mike Harris in Queen's Park. She was subsequently involved with the Ontario Coalition Against Poverty. She has recently scaled back her political activism. She was part of a group in 2001 which opposed the proposed Free Trade Area of the Americas. The 3rd Summit of the Americas was held in Quebec City in April 2001. In 2003, she was part of former Toronto mayor David Miller's transition advisory team.

Following the row with Disney, Polley dedicated more of her efforts to politics, becoming a prominent member of the Ontario New Democratic Party (ONDP), where Ontario legislator Peter Kormos was her political mentor. In 1996, she gave a nomination speech for Kormos at the ONDP leadership convention which she later referred to as the "proudest moment in [her] life".

In 1998, Polley appeared in the critically acclaimed film Last Night. The following year, she starred as part of the ensemble cast in the film Go.

In 1999, Polley made her first short film, The Best Day of my Life, for the On the Fly 4 Film Festival. She also made a second short film that year, Don't Think Twice. Polley attended the Canadian Film Centre's directing program in 2001, and won the Genie Award for Best Live Action Short Drama in 2003 for her short film I Shout Love.

She was cast in the role of Penny Lane in the big-budget 2000 film Almost Famous, but dropped out of the project to return to Canada for the low-budget The Law of Enclosures. Her role in the 2003 film My Life Without Me garnered the Genie Award for Best Performance by an Actress in a Leading Role in 2004. In the same year, she starred in a lead role in the remake of Dawn of the Dead, which was a departure from her other indie roles.

On September 10, 2003, she married Canadian film Editor David Wharnsby, her companion of seven years. They divorced in 2008.

In 2005, she starred in The Secret Life of Words, opposite Tim Robbins and Julie Christie. She was nominated as Best European Actress by the European Film Academy for her role as Hanna.

She made her feature-length film directing debut with Away from Her, which Polley adapted from the Alice Munro short story The Bear Came Over the Mountain. The movie, starring Julie Christie (with whom she had played in No Such Thing, 2001, and The Secret Life of Words, 2005), debuted at the Toronto International Film Festival on September 11, 2006, as part of the TIFF's Gala showcase.

In 2007, Polley discovered that the man who raised her was not her biological father. The story of her mother's affair and her biological father are detailed in her documentary Stories We Tell.

In 2008, Polley appeared as Nabby Adams in the HBO miniseries based on the life of John Adams. Polley played Elise in Jaco Van Dormael's Mr. Nobody, which was released in 2010. Critical response has praised the film's artistry and Polley's acting. Later that year, she also appeared in a cameo role in Bruce MacDonald's film Trigger.

In 2009, Polley directed a two-minute short film in support of the Heart and Stroke Foundation of Canada. In advance of the film's airing in Canada during the 82nd Academy Awards, and following news reports that characterized the film as a marketing exercise for the margarine company Becel, Polley withdrew her association with the film. "In December 2009, I made a film to be aired during the Academy Awards that I believed was to promote the Heart and Stroke Foundation. When I agreed to make this film ["The Heart"], I was thrilled, as I was proud to be associated with the work of this incredible organization. However, I have since learned that my film is also being used to promote a product. Regretfully, I am forced to remove my name from the film and disassociate myself from it. I have never actively promoted any corporate brand, and cannot do so now." In response, Becel said it was a "founding sponsor" of the Heart Truth campaign and had commissioned the film "to put heart health on the radar of Canadian women".

On October 16, 2010, it was announced that she would receive a star on Canada's Walk of Fame. In June 2013, she received the National Arts Centre Award recognizing achievement over the past performance year at the Governor General's Performing Arts Awards, where she was the subject of a short vignette by Ann Marie Fleming entitled Stories Sarah Tells. Polley was appointed an Officer of the Order of Canada on December 30, 2013.

On August 23, 2011, she married David Sandomierski, who is working on his PhD in law at the University of Toronto. Their daughter Eve was born on February 7, 2012. In August 2014, Polley revealed that she had given birth to a second daughter.

In January 2012, Polley endorsed Toronto MP Peggy Nash in the 2012 New Democratic Party leadership race to succeed Jack Layton.

Her first cinematic appearance was at the age of four, as Molly in the Disney film One Magic Christmas. She was also in the pilot episode for Friday the 13th – The Series, as well as appearing in a small role in william Fruet's sci-fi horror film Blue Monkey , both in 1987. At age eight, she was cast as Ramona Quimby in the television series Ramona, based on Beverly Cleary's books.

In June 2014, it was announced that she would be writing and directing an adaptation of John Green's Looking for Alaska. In 2015, it was announced that due to scheduling conflicts, Polley would no longer be directing the film.