"This should serve as a wake-up call for European companies," the report said. "While this catching up is most likely to occur in services, with breakthroughs in industrial goods taking longer, European business needs to plan accordingly."

By 2020, 60 percent of European companies in China expect Chinese firms to have closed the innovation gap, according to the EU Chamber of Commerce in China's annual business confidence survey.

China's rapid innovation is the latest headwind for foreign firms doing business in the country. International companies have long complained about the difficulties of operating within Chinese borders, given a murky regulatory environment, and perceived favorable treatment for domestic firms. But the prospect of finding growth in the world's second-largest economy is too great to ignore for many companies.

The EU Chamber's latest findings again underscore those same issues, with half of its member firms saying that conducting business in China became more difficult in 2016. Within that, more than 70 percent in hospitality and civil engineering and construction say doing business has grown more difficult, while in aerospace and aviation, the majority say things have stayed roughly the same.

"Respondents' doubts over whether China is truly committed to creating a simpler administrative environment and ensuring a level playing field continue to deepen," said the report. "Cumbersome regulations and vaguely-worded laws — often subject to arbitrary interpretation — continue to pose a range of challenges."

There is also still a bilateral trade and investment gap between the EU and China given the challenging regulatory environment and barriers to entry, the report finds. Chinese investment into Europe jumped 77 percent to 35 billion euros in 2016 compared to the prior year, but investment in the other direction fell 23 percent to 8 billion euros.

Although more than half of the companies surveyed clocked higher sales in 2016 compared to the year prior, it was largely attributed to large-scale financial stimulus that the Chinese government had unleashed in the first half of the year.

That means the bounce is not here to stay, and as such, the top concern for European firms in China remains the health of the economy — especially as the country's debt levels have continued to rise.

"How sustainable is the growth model? Isn't it time for China to go from talk to action?" said Mats Harborn, president of the European Union Chamber of Commerce in China, in an interview with CNBC. "We would want to see China go to more organically driven growth."

Following that is an "ongoing struggle to find and retain qualified employees, a problem aggravated by demands for higher compensation among local hires." The main challenge in attracting and keeping foreign employees is the issue of air pollution and an unwillingness to live in China.

Harborn said his organization was making proposals that China "deepen and speed up reform," which "should be beneficial also for the Chinese economy."

The study had 570 respondents from a wide range of sectors, with 35 percent in professional services, 35 percent in industrial goods and services, 18 percent in consumer goods and services and the remaining 12 percent in other sectors. About half were small and medium-sized enterprises with fewer than 250 employees, 19 percent had up to 1,000 employees, and nearly one-third reported more than 1,000 employees.