The reintroduction of Sphagnum fragments has been found to be a promising method for restoring mire vegetation in a cutaway peatland. Although it is known that moisture controls Sphagnum photosynthesis, information concerning the sensitivity of carbon dynamics on water-level variation is still scarce. In a 4-year field experiment, we studied the carbon dynamics of reintroduced Sphagnum angustifolium material in a restored (rewetted) cutaway peatland. Cutaway peatland restored by Sphagnum reintroduction showed high sensitivity to variation in water level. Water level controlled both photosynthesis and respiration. Gross photosynthesis (PG) had a unimodal response to water-level variation with optimum level at −12 cm. The range of water level for high PG (above 60% of the maximum light-saturated PG) was between 22 and 1 cm below soil surface. Water level had a dual effect on total respiration. When the water level was below soil surface, peat respiration increased rapidly along the lowering water level until the respiration rate started to slow down at approximately −30 cm. Contrary to peat respiration, the response of Sphagnum respiration to water-level variation resembled that of photosynthesis with an optimum at −12 cm. In optimal conditions, Sphagnum reintroduction turned the cutaway site from carbon source to a sink of 23 g C/m2 per season (mid-May to the end of September). In dry conditions, lowered photosynthesis together with the higher peat respiration led to a net loss of 56 g C/m2. Although the water level above the optimum amplitude restricted CO2 fixation, a decrease in peat respiration led to a positive CO2 balance of 9 g C/m2.