Crop production is threatened by both water scarcity and poor soil water retention in arid or semi-arid regions. At the same time, the industrial-scale accumulation of municipal sludge creates substantial environmental and resource pressures. The goal of this work was to recycle municipal sludge into a low-cost, environmentally friendly, and multifunctional sludge-based water-retaining material (SBWRM) for enhancing soil water retention capacity and nutritional status. Sludge was used as the primary raw material, and extracellular polymeric substances were extracted using a combined alkaline ultrasonic method. These extracts were then mixed with polyvinyl alcohol to prepare the sludge-based material. The water retention capacity of the material, as well as its effects on seed germination and plant growth in a planting substrate, were systematically evaluated. The results suggested that the SBWRM achieved a maximum water retention capacity of 18.7 times its own weight. The addition of 40% SBWRM effectively promoted ryegrass seed germination and plant height, increased soil moisture and pH value, and enhanced the nutrient contents of nitrogen, phosphorus, and potassium. The findings indicate that SBWRM can effectively enhance water conservation, soil quality, and nutrient supply, thereby providing a practical approach for utilizing sludge resources and supporting ecological restoration in agricultural systems.