Heterochromatic DNA domains have important roles in the regulation of gene expression and maintenance of genome stability by silencing repetitive DNA elements and transposons. From fission yeast to mammals, heterochromatin assembly at DNA repeats involves the activity of small noncoding RNAs (sRNAs) associated with the RNA interference (RNAi) pathway. Typically, sRNAs, originating from long noncoding RNAs, guide Argonaute-containing effector complexes to complementary nascent RNAs to initiate histone H3 lysine 9 di- and trimethylation (H3K9me2 and H3K9me3, respectively) and the formation of heterochromatin. H3K9me is in turn required for the recruitment of RNAi to chromatin to promote the amplification of sRNA. Yet, how heterochromatin formation, which silences transcription, can proceed by a co-transcriptional mechanism that also promotes sRNA generation remains paradoxical. Here, using Clr4, the fission yeast Schizosaccharomyces pombe homologue of mammalian SUV39H H3K9 methyltransferases, we design active-site mutations that block H3K9me3, but allow H3K9me2 catalysis. We show that H3K9me2 defines a functionally distinct heterochromatin state that is sufficient for RNAi-dependent co-transcriptional gene silencing at pericentromeric DNA repeats. Unlike H3K9me3 domains, which are transcriptionally silent, H3K9me2 domains are transcriptionally active, contain modifications associated with euchromatic transcription, and couple RNAi-mediated transcript degradation to the establishment of H3K9me domains. The two H3K9me states recruit reader proteins with different efficiencies, explaining their different downstream silencing functions. Furthermore, the transition from H3K9me2 to H3K9me3 is required for RNAi-independent epigenetic inheritance of H3K9me domains. Our findings demonstrate that H3K9me2 and H3K9me3 define functionally distinct chromatin states and uncover a mechanism for the formation of transcriptionally permissive heterochromatin that is compatible with its broadly conserved role in sRNA-mediated genome defence.