Abstract: The impact of regional leading firms’ knowledge diffusion on the innovation of local Small and Medium-sized Enterprises (SMEs) is one of the most important topics for both academic and practical researchers. A quite amount of research has introduced that leading firms’ knowledge diffusion path and SMEs’ absorptive capacity are significant to the effectiveness of leading firms’ knowledge diffusion on SMEs’ innovation. And there are two knowledge diffusion paths, one is the informal communication between a leading firm and a SME, the other is the collaboration relationship between them. With the survey data of 156 SMEs from 3 industrial clusters of Zhejiang, it is found that there is an important condition for the effectiveness of leading firms’ knowledge diffusion on local SMEs’ innovation. That is to say, weather or not leading firms’ knowledge diffusion has a driving effect on SMEs’ innovation depends on the matching of the knowledge diffusion path and the absorptive capacity of SME. SMEs that possess low absorptive capacity should communicate informally with leading firms to innovate, while SMEs with high absorptive capacity should collaborate with leading firms to promote its innovation.