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The Indian city of Surat, 250 kilometers north of Bombay, has the look of an industrial inferno. Textile mills belch smoke into Surat's discolored sky, mill workers live in dismal slums and homeless men nap alongside dogs on the railway-station floor. In 1994, the city achieved a moment of international fame when doctors announced pneumonic plague had resurfaced in its winding alleys. Nestled amid Surat's grime, however, is one of India's most extraordinary success stories. Whether you live in the U.S. or Japan, if you buy an engagement ring this year, there's a good chance you'll be taking home a diamond crafted here.

Every morning, more than a thousand diamond cutters file into Surat's spotless Venus Jewel factory, each pressing his thumb on an electronic fingerprint scanner that releases a turnstile. After removing footwear, to ensure they don't leave with diamonds stuck to their soles, the cutters are handed plastic bags filled with rough diamonds. Operating lathes and lasers, they slice, polish and facet the cloudy crystals into sparkling gems, churning out about $150 million worth each year. Venus and several hundred other factories, employing 300,000 cutters in total, have made Surat the heart of India's thriving diamond-polishing industry, which last year cut 92% of the world's diamond pieces and earned India $8 billion in exports.

Although India dominates the polishing business, it produces almost none of the world's diamonds. Most rough stones are mined in Angola, Botswana, Namibia and Russia, and then find their way to Antwerp, where ultra-orthodox Hasidic Jews form the nerve center of the international diamond trade. With contacts from Tel Aviv to New York City, Hasidic businessmen have controlled the polishing and selling of diamonds for generations—until, that is, the Indians began butting in.

Local lore has it that a Surat entrepreneur, returning with a boatload of diamond cutters from East Africa, set up the city's polishing industry in 1901. Business picked up in the 1970s, when India began cutting low-quality gemstones and exporting them to the U.S. Although Bombay is the commercial center of India's diamond business, its militant labor unions have increasingly driven the polishers to Surat, where wages for diamond cutters are lower, at $2,500-$3,500 a year, and workers are more pliable. In the past, Surat's diamond industry has been a hot spot of controversy, attracting accusations that some workshops employ children in sweatshop conditions. Many of Surat's diamond workshops are tiny family-run units, which makes it hard to gather reliable information about them. But recent studies suggest that the use of child labor, although not completely eradicated in Surat, is now miniscule and declining rapidly as the city's diamond industry consolidates into large professionally managed units.

All the workers in new factories like Venus Jewel are adult, and the work environment is comfortable and well lit, albeit pervaded by paranoia. Closed-circuit cameras monitor many parts of the factory, and S.P. Shah, whose family owns Venus Jewel, sits in front of four screens and watches obsessively. Although the industry is rife with rumors that workers are locked in factories if diamonds go astray, Shah denies that his own employees are ill treated. "If a stone goes missing," he says, "we try and persuade the workers to give it back, and this usually works."

Most diamond cutters, who come from poor villages around Surat, can expect to do well for themselves as they accumulate experience: a senior cutter can demand $5,000-$7,500 a year. At Blue Star, another Surat company, a glistening phalanx of employees' motorbikes parked outside proves that the workers have made it into the middle class.

Cheap labor allowed India to find a niche for itself in the diamond-polishing business, but that wasn't the country's only edge. The Surat diamond trade was built by a dynamic and enterprising religious community—the Palanpuri Jains, followers of an ancient religion that emphasizes nonviolence and vegetarianism. Jains account for 0.4% of India's population. The Palanpuris, who hail from the town of Palanpur in the Indian state of Gujarat, form a close-knit community that thrives in the atmosphere of secrecy and informality that envelops the diamond trade—there are often no written contracts, many transactions occur in cash, and stones worth millions of dollars are transported with virtually no security. "It's an industry built on trust," says Biju Patnaik, a Bombay-based diamond-industry expert at Dutch bank ABN AMRO. The Palanpuris have also ventured over-seas, setting up small family-run polishing centers in Antwerp and Tel Aviv, and slowly elbowing into the U.S. as diamond sellers. In Manhattan's midtown diamond district, Palanpuri businessmen sitting beneath portraits of their saint, Mahavira, now run shops side by side with black-coated Hasidim from Brooklyn.

The Palanpuris are starting to eye even bigger game. Long known for churning out lower-quality diamonds, Surat's workshops are now moving into larger, pricier stones. It's an irresistibly lucrative market, with the costliest 10% of stones accounting for half of the value of all the world's diamonds. These top-quality stones are still mostly cut in Antwerp, New York and Tel Aviv, where many of Surat's companies have set up branches in which Indian diamond cutters are absorbing skills from local experts. Arjav Mehta, whose family owns Blue Star, says his company has hired 15 master cutters in Belgium and Israel: "There's a lot we're learning from them." Another ambition among the Palanpuris is for Surat to dethrone Antwerp as the world's center for the diamond trade. That will take some doing; Gujarat, the state in which Surat is located, suffered a blow to its international reputation because of anti-Muslim riots in 2002. Still, Surat's businessmen remain hopeful, and an international airport is being constructed to lure the world's businessmen to the city.

Although relations between the Palanpuris and the Hasidim are cordial, Surat's diamond traders admit that India's sudden rise to prominence has caused some resentment in Israel and Belgium. One Israeli analyst frets that Surat's bustling workshops are flooding retail stores with diamonds, which could depress prices for years to come. ABN AMRO's Patnaik points out, however, that the market for diamonds could expand quickly as the burgeoning middle classes of China and India develop more of a taste for diamond jewelry. To make sure they secure a foothold in the Chinese market, some Surat businessmen have even started setting up workshops in China; another bonus is that wages there are lower than in India. Small wonder that many Indian merchants believe it's only a matter of time before they take over from Belgium's Hasidim as kingpins of the diamond business. Venus Jewel's S.P. Shah, diverting his eyes for a moment from his four closed-circuit TVs, acknowledges that his Belgian and Israeli rivals are among the world's best businessmen, but he adds: "We Indians are even better."

• Aravind Adiga | Surat
• Buying a diamond ring? Chances are it was cut and polished in the Indian city of Surat, which has emerged as a dominant, low-cost player in the global diamond trade