In its early days, Hong Kong with its dry and largely infertile mountainous terrain was regarded as an uninviting prospect for settlement. A population of about 3 650 was scattered over 20 villages and hamlets, and 2 000 fishermen lived on board their boats in the sheltered harbour — Hong Kong's one natural asset. Victoria Harbour was strategically located on the trade routes of the Far East, and was soon to become the hub of a burgeoning entrepôt trade with China.

Hong Kong's development into a commercial centre began with British settlement in 1841. At the end of the 18th century, the British dominated the foreign trade in Canton (Guangzhou) but found conditions unsatisfactory, mainly because of the conflicting viewpoints of two quite dissimilar civilisations. The Chinese regarded themselves as the only civilised people, and foreigners trading in Canton were subject to residential and other restrictions. Confined to the factory area, they were allowed to remain only for the trading season, during which they had to leave their families in Macao. They were forbidden to enter the city or to learn the Chinese language. Shipping dues were arbitrarily varied and much bickering resulted between the British and Chinese traders. Yet, there was mutual trust and the spoken word alone was sufficient for even the largest transactions.

Trade had been in China's favour and silver flowed in until the growth of the opium trade — from 1800 onwards — reversed this trend. The outflow of silver became more marked from 1834, after the East India Company lost its monopoly of the China trade, and the foreign free traders, hoping to get rich quickly, joined the lucrative opium trade which the Chinese had made illegal in 1799. This led to the appointment of Lin Zexu (Lin Tse-hsu) in March 1839 as special Commissioner in Canton with orders to stamp out the opium trade. A week later, he surrounded the foreign factories with troops, stopped food supplies and refused to let anyone leave until all stocks of opium had been surrendered and dealers and ships' masters had signed a bond not to import opium on pain of execution. Captain Charles Elliot, RN, the British Government's representative as Superintendent of Trade, was shut up with the rest and authorised the surrender of 20 283 chests of opium after a siege of six weeks.

Elliot would not allow normal trade to resume until he had reported fully to the British Government and received instructions. The British community retired to Macao and, when warned by the Portuguese Governor that he could not be responsible for their safety, took refuge on board ships in Hong Kong harbour in the summer of 1839.

The British Foreign Secretary, Lord Palmerston, decided that the time had come for a settlement of Sino-British commercial relations. Arguing that, in surrendering the opium, the British in Canton had been forced to ransom their lives — though, in fact, their lives had never been in danger — he demanded either a commercial treaty that would put trade relations on a satisfactory footing, or the cession of a small island where the British could live under their own flag free from threats.

An expeditionary force arrived in June 1840 to back these demands, and thus began the so-called First Opium War (1840-42). Hostilities alternated with negotiations until agreement was reached between Elliot and Qishan (Keshen), the Manchu Commissioner who had replaced Lin after the latter was exiled in disgrace over the preliminaries of a treaty.

Under the Convention of Chuenpi (Chuanbi) signed on January 20, 1841, Hong Kong Island was ceded to Britain. A naval landing party hoisted the British flag at Possession Point (in the vicinity of present-day Hollywood Road Park in Sheung Wan) on January 26, 1841, and the island was formally occupied. In June, Elliot began to sell plots of land and settlement began.

Neither side accepted the Chuenpi terms. The cession of a part of China aroused shame and anger among the Chinese, and the unfortunate Qishan was ordered to Peking (Beijing) in chains. Palmerston was equally dissatisfied with Hong Kong, which he contemptuously described as 'a barren island with hardly a house upon it', and refused to accept it as the island station that had been demanded as an alternative to a commercial treaty.

'You have treated my instructions as if they were waste paper,' Palmerston told Elliot in a magisterial rebuke, and replaced him. Elliot's successor, Sir Henry Pottinger, arrived in August 1841 and conducted hostilities with determination. A year later, after pushing up the Yangtze River (Chang Jiang) and threatening to assault Nanking (Nanjing), he brought the hostilities to an end by the Treaty of Nanking, signed on August 29, 1842.

In the meantime, the Whig Government in England had fallen and, in 1841, the new Tory Foreign Secretary, Lord Aberdeen, issued revised instructions to Pottinger, dropping the demand for an island. Pottinger, who had returned to Hong Kong during the winter lull in the campaign, was pleased with the progress of the new settlement and, in the Treaty of Nanking, deviated from his instructions by demanding both a treaty and an island, thus securing Hong Kong.

Five Chinese ports, including Canton, were also opened for trade. The commercial treaty was embodied in the supplementary Treaty of the Bogue (Humen) in October 1843, by which the Chinese were allowed free access to Hong Kong Island for trading purposes.