The vastly spreading COVID-19 pneumonia is caused by SARS-CoV-2. Lymphopenia and cytokine levels are tightly associated with disease severity. However, virus-induced immune dysregulation at cellular and molecular levels remains largely undefined. Here, the leukocytes in the pleural effusion, sputum, and peripheral blood biopsies from severe and mild patients were analyzed at single-cell resolution. Drastic T cell hyperactivation accompanying elevated T cell exhaustion was observed, predominantly in pleural effusion. The mechanistic investigation identified a group of CD14 monocytes and macrophages highly expressing and in the biopsies from severe patients, suggesting M2 macrophage polarization. These M2-like cells exhibited up-regulated (M-CSF), and signaling pathways. Further, cell type specific dysregulation of transposable elements was observed in Severe COVID-19 patients. Together, our results suggest that severe SARS-CoV-2 infection causes immune dysregulation by inducing M2 polarization and subsequent T cell exhaustion. This study improves our understanding of COVID-19 pathogenesis.