The name comes from Mapudungun, the Mapuche language. Colhué means a red or reddish place, and Huapi means island, so the lake may have been named for one of its rocky islets or for the clay-brown color of its water. For most of its history it was a true lake, shallow but enormous, fed indirectly by the Senguerr River, which carries Andean meltwater hundreds of kilometers across the plateau. Paired with deeper Lake Musters nearby, Colhué Huapi formed the terminal basin of that river system. Its shores were studded with peninsulas, the largest of them, the Grande or Namuncurá peninsula, running some 20 kilometers north to south. When full, the lake could rise high enough to flood the road to Sarmiento.

The Tehuelche people, who knew this lake long before European settlers arrived, told of a creature in its waters they called the lemisch, the water tiger. They described it as a supernatural beast, nocturnal and bellowing, terrifying and, in their accounts, immune even to rifle fire. The story reached the scientific world through Carlos Ameghino, who traveled Patagonia collecting fossils for his brother, the famed naturalist Florentino Ameghino. Carlos reported handling a piece of lemisch hide studded with small embedded bones, sent to Florentino, who found it resembled the fossilized remains of Mylodon, the extinct giant ground sloth. Whatever the lemisch truly was, tales of the monster persisted into the twentieth century, fading only as the great droughts began to empty the lake of the water that had hidden it.

It is hard to picture now, but Colhué Huapi was once an oasis. Through the first half of the twentieth century the land around it was green with farms, fruit trees, and plantations, productive enough that local estancias made cheese for sale. Scientists studying the lake in the 1980s labeled it an oasis of productivity in an arid land: shallow water, stirred constantly by wind, grew rich in nutrients and supported huge quantities of zooplankton, which fed thriving populations of perch and silverside. A commercial fishery flourished here in the 1970s, with fishermen working simple boats across waters too shallow to build the dangerous swell of neighboring Musters. The lake gave people a living. Then, slowly and then all at once, it stopped.

The drying has been blamed on both nature and people. A long regional drought since around 2000 cut the water, but so did human action: the diversion of the Senguerr River through embankments to irrigate crops, leaving little to reach the lake. By 2017 Colhué Huapi had dried almost completely, and the national attention it drew came partly from a grim discovery in 2016, the wreck of a light aircraft that had crashed in 1964 carrying four people, all of whom died, found at last in the receding lake bed. Residents of Sarmiento marched in protest, even dismantling illegal embankments themselves when authorities would not act. Today strong northwesterly winds lift the lake's fine, silica-rich sediment and carry it more than 120 kilometers, dangerous to breathe and harsh on the eyes. NASA has called the dry lake the largest and most active source of dust storms in the region, its sediment drifting out to sea and possibly as far as Antarctica.