This is an ancient tradition and as such there are several different supposed origins of the Lantern Festival.

One legend states that the first lantern festival took place during the Han Dynasty, about two thousand years ago. 

The legend goes that during the reign of Emperor Wu there was a palace maid named Yuansiao, whose role forbid her from ever seeing her family. This made her very homesick. A minister from the palace took pity on her and came up with a plan to reunite the maid with her parents for one night of the year. He told the emperor that the God of Heaven was displeased and would destroy the city by fire unless lanterns were hung throughout the city on his birthday.

On this night, servants and maids were to be permitted to leave the palace to help take part in the ritual, giving Yuansiao and evening a year to be with her family.

According to another legend, the Jade Emperor, the highest God in Heaven, was so angered at the people of a town who had killed his favourite goose that he decided to destroy them with a storm of fire on the fifteenth day of the first lunar month.

However, a good-hearted fairy heard of the Emperor’s plan for vengeance and told the townsfolk to light lanterns on the appointed day. They acted accordingly, and from the Heavens, the lights from the lanterns made it look as if the town was already ablaze. Satisfied that his goose had already been avenged, the Jade Emperor decided not to destroy the town.

The history of Lantern Festival can be traced back to the time when Emperor Wen of the Western Han Dynasty (206 BC – 25 AD) officially set the 15th day of the first month of the Chinese calendar as the Yuan Xiao Festival. It has been celebrated as the birthday of the God of Heaven (Shang Yuan Jie), since the Tang dynasty (618 AD – 907 AD).