Organic carbon is a critical component of aquatic systems, providing energy storage and transfer between organisms. Fungi are a major decomposer group in the aquatic carbon cycle, and are one of few groups thought to be capable of breaking down woody (lignified) tissue. In this work we have used high spatial resolution (synchrotron light source) infrared micro-spectroscopy to study the interaction between aquatic fungi and lignified leaf vein material (xylem) from River Redgum trees (E. camaldulensis) endemic to the lowland rivers of South-Eastern Australia. The work provides spatially explicit evidence that fungal colonisation of leaf litter involves the oxidative breakdown of lignin immediately adjacent to the fungal tissue and depletion of the lignin-bound cellulose. Cellulose depletion occurs over relatively short length scales (5–15 µm) and highlights the likely importance of mechanical breakdown in accessing the carbohydrate content of this resource. Low bioavailability compounds (oxidized lignin and polyphenols of plant origin) remain in colonised leaves, even after fungal activity diminishes, and suggests a possible pathway for the sequestration of carbon in wetlands. The work shows that fungi likely have a critical role in the partitioning of lignified material into a biodegradable fraction that can re-enter the aquatic carbon cycle, and a recalcitrant fraction that enters long-term storage in sediments or contribute to the formation of dissolved organic carbon in the water column.