The NSW government will hand back more than $250 million to a Chinese mining giant to scale back a coal mining exploration licence on the Liverpool Plains.

It says the decision will protect prime agricultural land but the opposition and environmentalists say prime land in north-eastern NSW is still at risk of contamination and the company has been treated too generously.

The state government announced on Wednesday that it would refund nearly $262 million in inflation-adjusted dollars to Shenhua Watermark in exchange for it handing back about 51 per cent of the exploration licence originally awarded by the previous state Labor government for one mine.

NSW Energy Minister Don Harwin said the new boundaries meant the region's fertile soil would be protected from any exploration activity.

"There will be no mining on the fertile black soils of the Liverpool Plains," he said."The NSW government is acting to protect prime agricultural land."

But Labor argues Shenhua should have its entire licence cancelled without any compensation.

Shenhua paid the former NSW Labor Government $300 million for the original exploration licence in 2008 which was later renewed after the coalition took office. Opposition Leader Luke Foley said the past Labor government had got that decision wrong.

"The entire proposal should be brought to an end," he said. "There's still a risk to the water table if mining should proceed."

Labor argues no money should be returned to the company because it claims the company violated a contract clause that requires substantial exploration activity to have taken place during the duration of the licence.

"A quarter of a billion dollars to the company is unjustifiable corporate welfare," Mr Foley said. "It was a condition of the [agreement] that substantial development ... needs to occur within the eight-year period".

Mr Harwin said more work had to be done before he would consider whether any mining would be approved in the remaining licence areas that remained within the boundaries of the scaled-back licence.

Shenhua - a state-owned corporation - has approval to explore the ridge lands, under strict water management arrangements and other conditions.

Minister for Regional Water, Niall Blair, said any future mining would have to be governed by strict water management.

"Shenhua's proposed activities on the ridge country have been exhaustively assessed and considered under the NSW Aquifer Interference Policy," he said.

Liu Xiang, Chairman of Shenhua Australia expressed "disappointment" with the decision but said the company would continue exploration within the boundaries the truncated licence :

"The Watermark Coal Mine has been subject to unprecedented scrutiny which has demonstrated the project can be developed in an environmentally sustainable manner," he said.

The mine caused heavy divisions within the federal Coalition government and had been condemned by the Nationals' federal leader Barnaby Joyce, despite being given conditional planning approval by his government.

At its previous approval, the impact size of the proposed mine, located about 25 kilometres south-east of Gunnedah in north-eastern NSW, was larger than the City of Sydney.

The decision was angrily condemned by the Lock The Gate Alliance, a group opposed to mining near agricultural areas.

"We've been betrayed by the NSW government. If it was serious about protecting farmland, it would have cancelled the coal licence outright and stopped this coalmine," Breeza farmer Andrew Pursehouse, whose property is near the proposed mine, said.

The NSW Greens condemned the decision and said the government must cancel the entire licence to ensure any potential future mining on the ridge does not extend to the Liverpool Plains.

"Anything less than full cancellation does not lift the threat," mining spokesman Jeremy Buckingham said. "The idea that you can dig a 300-metre deep pit next to a flood plain and it will not impact on the water table is ridiculous."

Up to 600 jobs would continue to be created under the deal, local MP Kevin Andrews said.

A second licence in the Liverpool Plains area, BHP's Caroona project, was also bought back by the state government last year.