The Himalayan state's Comptroller and Auditor General said that tests of water samples collected at the lake showed a high presence of metals like iron, manganese, copper, lead, cadmium and arsenic.
"Effects of these elements can cause damage to brain, liver and kidneys of the consumers", the report warned.
The scenic Dal lake in the heart of Kashmir's summer capital, Srinagar, is surrounded by snow-capped mountains and is home to 2,000 ornately-carved pinewood houseboats, whose owners are still dependent on tourism despite 17 years of a violent insurgency.
More than 400,000 tourists visited Indian Kashmir in 2006 and thousands of fishermen and farmers live on and near the lake.
The report said an increasing amount of waste and sewage was being discharged into the Dal lake and accumulating in the fish and water which was then consumed by humans, posing a serious health risk.
The CAG report said arsenic, which was found to be present almost 1,000 times more than what is permissible, also threatened several species of fish.
Seventeen out of