Polley, the youngest of five children, was born in Toronto, Ontario. She is the daughter of Diane Elizabeth (née MacMillan), an actress and casting director, and Michael Polley, a British-born actor and insurance agent (he attended acting classes with Albert Finney in England before moving to Canada). Polley's mother died of cancer just after Polley's 11th birthday. Polley attended Subway Academy II, then Earl Haig Secondary School, but dropped out before graduating.

Her first cinematic appearance was at the age of four, as Molly in the Disney film One Magic Christmas. At age eight, she was cast in the title role in the television series Ramona, based on Beverly Cleary's books. That same year, she also played one of the lead characters in Terry Gilliam's The Adventures of Baron Munchausen. Polley burst into the public eye the following year 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.[citation needed]

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, and she left Road to Avonlea in 1994. The show itself was cancelled in 1996 (to which she publicly claimed indifference), although she did return as Sara Stanley for an episode in 1995 and for the final episode in 1996.[citation needed]

Polley appeared as Lily on the CBC television series, Straight Up. It ran from 1996–1998 and she won the Gemini Award for Best Performance in a Children's or Youth Program or Series for her role. Polley's subsequent role as Nicole Burnell in the 1997 film The Sweet Hereafter, brought her considerable attention in the United States; she was a fan favourite at the Sundance Film Festival. Her character in the film was an aspiring singer — on the soundtrack, she performed a cover of The Tragically Hip's "Courage" and Jane Siberry's "One More Colour", as well as the film's title track which she co-wrote with Mychael Danna. "Courage" was also played in the ending of an episode of Charmed, "Long live the Queen" (Season 4 Episode 20).

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 stylish and successful remake of Dawn of the Dead, which was a departure from her other indie roles. 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, based on the Alice Munro short story The Bear Came Over the Mountain. The movie, starring Julie Christie, debuted at the Toronto International Film Festival on September 11, 2006 as part of the TIFF's Gala showcase. Away From Her was acquired by Lionsgate for release in the US for the sum of $750,000. It drew rave reviews from Variety, The Hollywood Reporter, and the three Toronto dailies, both for the performances of Christie and her co-star, Canadian actor Gordon Pinsent, and for Polley's direction. It also earned Polley a 2008 Academy Award nomination for her adapted screenplay and won the Genie Award for Best Achievement in Direction (the first woman to do so). At the 2008 Genies, she was also awarded the Claude Jutra Award, which recognizes outstanding achievement by a first-time feature film director.

Polley takes pride in her work and enjoys both acting and directing but is not keen on combining the two. "I like the feeling of keeping them separate. I find that really gratifying. I can't imagine combining those. For me, I love the feeling of using different parts of my brain separately."

In 2009, Polley directed a two-minute short 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."

Following the row with Disney, Polley dedicated more of her efforts to politics, becoming a prominent member of the New Democratic Party, where Ontario legislator Peter Kormos was said to be her political mentor.

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 on her political activism.