The Blues conceded twice before the break on a rare off-night for the Premier League champions.
Though the hosts were much-improved in the second period, an impressive Lyon held out for the win.
City, with three changes from the side that beat Fulham, had to work hard to create openings in the first-half.
Lyon, looking more like Blackpool in their all-tangerine strip, defended in numbers and pressed the Blues whenever in possession.
Raheem Sterling worked himself a couple of half-chances but saw his efforts go wide on each occasion.
Aymeric Laporte headed against the post from Ilkay Gundogan’s cross on 17 minutes, but it was the visitors who struck first as Nabil Fekir’s cross was misjudged by Fabian Delph and Maxwel Cornet made no mistake from six yards.
The Blues just weren’t at the races and after surviving another attack where shots were peppered at the goal in succession, Lyon increased their lead shortly after as Fekir drilled a low shot past Ederson from 20 yards out.
City suddenly had a mountain to climb.
The Blues were brighter after the break, but with ten men behind the ball, space was at a premium and the opportunities created were no more than half-chances.
The French side almost went three up as Memphis Depay raced clear on the counter-attack but a magnificent save by Ederson meant the ball hit the inside of the post rather than the back of the net.
City finally hauled themselves back into the game with a goal created by some Leroy Sane magic.
The German winger skipped past two challenges on the left before picking out Bernardo who swept a low shot home to half the deficit – suddenly it was game on.
City pushed for an equaliser and Sergio Aguero's burst into the box and shot was the closest anyone came to levelling the scores on an ultimately frustrating night at the Etihad.
Bad day at the office?
No team is immune from an off-day and that’s what City had against Lyon.
It’s hard to point to anything specific, but it was a collective dip that resulted in too many misplaced passes that were punished by a more than useful Lyon side.
The positive not from this game is that it is only Matchday 1 – there are five games for the Blues to put this result right and progress in the competition.
Star man: Bernardo Silva
Never stopped trying or making himself available and was rewarded with a goal if nothing else.
What it means:
With Shakhtar and Hoffenheim drawing 2-2 in Ukraine, the Blues sit at the bottom of Group F after the first round of matches.
“It could have been better. We started slowly, and we were inconsistent in the way we wanted to play.
“We lost too many duels. We gave the ball away in difficult circumstances and they scored twice, but after that, the reaction from the lads was superb.
“We tweaked a few things to control situations better and we created chances, but at this level, it wasn’t enough.
“We were very aware of Lyon’s strengths and weaknesses. They were well prepared.
“We weren’t prepared to be 2-0 down at the break, but you have to react.
“There is zero margin for errors in the Champions League – you make a mistake and you are punished. If you don’t win duels, play simple balls, you will suffer - today was an example of that.
"Sometimes a new competition you have to get on track. The start wasn’t good. We didn’t feel the flow around the team.
“We missed the right pass and didn’t find consistency. We felt under threat every time we lost the ball, that can bring the confidence lower. We were ready for the game, keen to start to Champions League because the way we ended it last season really hurt.
“The players are not perfect, sometimes they have bad days, sometimes better. I can’t fault the effort. I won’t judge them because we lost.”
City travel to South Wales to face Cardiff City on Saturday as the champions return to Premier League action.