diff --git a/lib/contracts/state-service.ts b/lib/contracts/state-service.ts
new file mode 100644
index 0000000..4fc1e7f
--- /dev/null
+++ b/lib/contracts/state-service.ts
@@ -0,0 +1,148 @@
+import { sql } from "@/lib/db";
+import { dispatchNotification } from "@/lib/notifications";
+
+export type ContractStatus = 
+  | 'draft'
+  | 'pending'
+  | 'pending_funding'
+  | 'active'
+  | 'submitted'
+  | 'completed'
+  | 'cancelled'
+  | 'disputed'
+  | 'paused';
+
+export interface TransitionStateInput {
+  contractId: string;
+  newStatus: ContractStatus;
+  userId: string;
+  reason?: string;
+  contractName?: string;
+}
+
+export class ContractStateError extends Error {
+  constructor(message: string) {
+    super(message);
+    this.name = 'ContractStateError';
+  }
+}
+
+// Define valid state transitions
+const VALID_TRANSITIONS: Record<ContractStatus, ContractStatus[]> = {
+  draft: ['pending_funding', 'cancelled'],
+  pending: ['active', 'cancelled', 'pending_funding'], // Legacy support
+  pending_funding: ['active', 'cancelled'],
+  active: ['submitted', 'disputed', 'cancelled', 'completed', 'paused'],
+  paused: ['active', 'cancelled', 'disputed'],
+  submitted: ['completed', 'active', 'disputed', 'cancelled'],
+  disputed: ['completed', 'cancelled', 'active'],
+  completed: [], // Terminal state
+  cancelled: [], // Terminal state
+};
+
+export class ContractStateService {
+  /**
+   * Transitions a contract from its current state to a new state.
+   * Enforces rules, logs the transition, and broadcasts events.
+   *
+   * @throws ContractStateError if the transition is invalid or contract not found
+   */
+  async transitionState(input: TransitionStateInput): Promise<void> {
+    const { contractId, newStatus, userId, reason } = input;
+
+    // Fetch the current status and users
+    const rows = await sql`
+      SELECT status, client_id, freelancer_id 
+      FROM contracts 
+      WHERE id = ${contractId}
+    `;
+
+    if (rows.length === 0) {
+      throw new ContractStateError(`Contract with id ${contractId} not found.`);
+    }
+
+    const contract = rows[0];
+    const currentStatus = contract.status as ContractStatus;
+    const clientId = contract.client_id as string;
+    const freelancerId = contract.freelancer_id as string;
+
+    // Validate transition
+    if (currentStatus === newStatus) {
+      return; // No-op
+    }
+
+    const allowedTransitions = VALID_TRANSITIONS[currentStatus] || [];
+    if (!allowedTransitions.includes(newStatus)) {
+      throw new ContractStateError(
+        `Invalid state transition from '${currentStatus}' to '${newStatus}'.`
+      );
+    }
+
+    // Execute updates within a transaction using our SQL template
+    await sql.begin(async (sqlTransaction) => {
+      // 1. Update the contract status
+      await sqlTransaction`
+        UPDATE contracts
+        SET status = ${newStatus}::contract_status, updated_at = NOW()
+        WHERE id = ${contractId}
+      `;
+
+      // 2. Insert the audit log
+      await sqlTransaction`
+        INSERT INTO contract_state_logs (
+          contract_id, previous_status, new_status, changed_by_user_id, reason
+        ) VALUES (
+          ${contractId}, 
+          ${currentStatus}::contract_status, 
+          ${newStatus}::contract_status, 
+          ${userId}, 
+          ${reason || null}
+        )
+      `;
+    });
+
+    // 3. Broadcast notifications outside the transaction to avoid rollback issues
+    const contractName = input.contractName || 'Contract';
+    const notificationPayload = {
+      contractId,
+      contractName,
+      previousStatus: currentStatus,
+      newStatus,
+      reason,
+    };
+
+    // Notify client
+    if (userId !== clientId) {
+      await dispatchNotification(clientId, 'contract_state_changed', notificationPayload)
+        .catch(err => console.error(`Failed to notify client ${clientId}:`, err));
+    }
+
+    // Notify freelancer
+    if (userId !== freelancerId) {
+      await dispatchNotification(freelancerId, 'contract_state_changed', notificationPayload)
+        .catch(err => console.error(`Failed to notify freelancer ${freelancerId}:`, err));
+    }
+  }
+
+  /**
+   * Fetches the audit trail for a specific contract.
+   */
+  async getContractStateLogs(contractId: string) {
+    const rows = await sql`
+      SELECT 
+        l.id, 
+        l.previous_status, 
+        l.new_status, 
+        l.reason, 
+        l.created_at,
+        u.display_name as changed_by
+      FROM contract_state_logs l
+      LEFT JOIN users u ON l.changed_by_user_id = u.id
+      WHERE l.contract_id = ${contractId}
+      ORDER BY l.created_at DESC
+    `;
+    return rows;
+  }
+}
+
+export const contractStateService = new ContractStateService();
diff --git a/lib/db/migrations/008_contract_lifecycle_states.sql b/lib/db/migrations/008_contract_lifecycle_states.sql
new file mode 100644
index 0000000..bfc13c0
--- /dev/null
+++ b/lib/db/migrations/008_contract_lifecycle_states.sql
@@ -0,0 +1,32 @@
+-- Migration 008: Contract Lifecycle States
+
+-- Note: Postgres does not support adding values inside a transaction if the enum
+-- is created in the same transaction. However, these ENUMs exist in 001.
+-- ALTER TYPE ... ADD VALUE cannot be executed inside a transaction block 
+-- prior to Postgres 12. TaskChain likely uses modern Postgres, but we'll issue them individually.
+
+COMMIT; -- Ensure we are not in a transaction block if the runner wraps this
+
+ALTER TYPE contract_status ADD VALUE IF NOT EXISTS 'draft';
+ALTER TYPE contract_status ADD VALUE IF NOT EXISTS 'pending_funding';
+ALTER TYPE contract_status ADD VALUE IF NOT EXISTS 'submitted';
+
+BEGIN;
+
+CREATE TABLE IF NOT EXISTS contract_state_logs (
+  id               UUID        PRIMARY KEY DEFAULT gen_random_uuid(),
+  contract_id      UUID        NOT NULL REFERENCES contracts (id) ON DELETE CASCADE,
+  previous_status  contract_status,
+  new_status       contract_status NOT NULL,
+  changed_by_user_id UUID      REFERENCES users (id) ON DELETE SET NULL,
+  reason           TEXT,
+  created_at       TIMESTAMPTZ NOT NULL DEFAULT NOW()
+);
+
+CREATE INDEX IF NOT EXISTS idx_contract_state_logs_contract_id 
+  ON contract_state_logs (contract_id);
+
+CREATE INDEX IF NOT EXISTS idx_contract_state_logs_created_at 
+  ON contract_state_logs (created_at DESC);
+
+COMMIT;
diff --git a/lib/notifications.ts b/lib/notifications.ts
index 9c0777b..8320956 100644
--- a/lib/notifications.ts
+++ b/lib/notifications.ts
@@ -17,6 +17,7 @@ export type NotificationType =
   | "milestone_submitted"
   | "funds_released"
   | "contract_created"
+  | "contract_state_changed"
   | "dispute_raised"
   | "escrow_funded"
   | "escrow_refunded"
@@ -246,6 +247,10 @@ const CONTENT_BUILDERS: Record<
     title: "Contract created",
     body: `New contract "${str(p, "contractName") ?? "Untitled"}" created.`,
   }),
+  contract_state_changed: (p) => ({
+    title: "Contract status updated",
+    body: `Contract "${str(p, "contractName") ?? "Untitled"}" is now ${str(p, "newStatus") ?? "updated"}.`,
+  }),
   dispute_raised: (p) => ({
     title: "Dispute opened",
     body: `A dispute has been opened on your contract: ${str(p, "reason") ?? "see the dispute page for details"}.`,