Abstract: Research on the relationship between income inequality and happiness can be grouped into two major analytic perspectives: social comparison and social norm. The former, by focusing income inequality at individual level, argues that happiness depends on perceived gaps within reference groups in society. The latter, by looking at income inequality at aggregate level, believes that income disparity in society as a whole is an important source of individual unhappiness. From the social norm perspective, this paper applies the multilevel logistic model of analysis on the data from the Chinese General Social Survey to examine the effect of income inequality on happiness as well as its mechanism. The results show that the sever income inequality brought by the rapid economic growth and social transformation has a detrimental effect on people's happiness in China. However, the depth of the effect is different between low-income groups and high income-groups. People in low-income strata are much more affected by income inequality in their sense of wellbeing. Relative deprivation and relationship trust form an important social psychological mechanism that influences the relationship between income inequality and happiness. The conclusion is that happiness is not entirely determined on the existence of income inequality itself but the fairness of income distribution in society. Therefore, a fair and just income distribution system is the key to improve happiness of Chinese citizens.