Conservation groups say new cracks in the riverbed of one of Woronora Dam's major tributaries have leached iron and other minerals, turning the stream's once pristine waters a murky green.
The conservationists say Peabody Energy's latest longwall operation at the Metropolitan Mine, Helensburgh, is to blame for the damage and are concerned the quality of the area's drinking water could be at risk.
The company denies the claim.
Representatives from five local environment groups visited the Waratah Rivulet on Tuesday, taking photos to show numerous fractures in the rocks and waterfalls surrounding the waterway, as well as a rust-red compound floating around the edge of the cloudy green water.
"The water is the colour of pea soup," National Parks Association member Julie Sheppard said.
"This is totally unacceptable damage to any waterway, let alone one which is part of Sydney's drinking water catchment."
Northern Illawarra Sustainability Alliance co-ordinator Peter Turner said he last visited the area in December and had not expected to see such serious damage during this week's visit.
"The first thing I noticed was the green water and also the orange-red around the edges was much more prominent," Mr Turner said.
"As we walked down to the area where the most recent longwall was, we passed over a crack we had seen before . . . and it was wider than it was last time. We also noticed the face of a waterfall we were admiring a year ago had been broken."
Peabody Energy's external affairs manager, Jennifer Morgans, denied any damage to the quality of drinking water and said the green water was caused by normal stagnation and possibly a lack of rain. She said iron levels in the water were measured and fell within acceptable levels, according to Peabody's mining licence conditions.
Ms Morgans said the company had strict environmental controls in place and expected some cracks to form in the riverbeds when its new longwall mine was drilled under the stream earlier this year.
"To mitigate that, our longwall panels are significantly narrower than industry norms and this helps preserve the environmental values of the area," she said.
A spokeswoman from the Environment Protection Authority said the watchdog was aware of community concerns but did not have jurisdiction over what happened below the surface of the mine.
The Sydney Catchment Authority (SCA) said it was "aware of the surface cracking, iron staining and water discolouration at some locations within the Waratah Rivulet". But it added, "They appear to be localised".