Neuropathic lysosomal storage disorders (LSDs) present with activated pro‐inflammatory microglia. However, anti‐inflammatory treatment failed to improve disease pathology. We characterise the mechanisms underlying microglia activation in Niemann–Pick disease type A (NPA). We establish that an NPA patient and the acid sphingomyelinase knockout (ASMko) mouse model show amoeboid microglia in neurodegeneration‐prone areas. In vivo microglia ablation worsens disease progression in ASMko mice. We demonstrate the coexistence of different microglia phenotypes in ASMko brains that produce cytokines or counteract neuronal death by clearing myelin debris. Overloading microglial lysosomes through myelin debris accumulation and sphingomyelin build‐up induces lysosomal damage and cathepsin B extracellular release by lysosomal exocytosis. Inhibition of cathepsin B prevents neuronal death and behavioural anomalies in ASMko mice. Similar microglia phenotypes occur in a Niemann–Pick disease type C mouse model and patient. Our results show a protective function for microglia in LSDs and how this is corrupted by lipid lysosomal overload. Data indicate cathepsin B as a key molecule mediating neurodegeneration, opening research pathways for therapeutic targeting of LSDs and other demyelinating diseases.