diff --git a/CHANGELOG.md b/CHANGELOG.md
index b5f8c123b..87fc15f2e 100644
--- a/CHANGELOG.md
+++ b/CHANGELOG.md
@@ -4,6 +4,9 @@
 
 v2.11.0 is a feature release with the following enhancements:
 
+### Fixes
+- Fix error propagation rule for Python's C API to prevent SystemError when callbacks raise exceptions (#865)
+
 confluent-kafka-python v2.11.0 is based on librdkafka v2.11.0, see the
 [librdkafka release notes](https://github.com/confluentinc/librdkafka/releases/tag/v2.11.0)
 for a complete list of changes, enhancements, fixes and upgrade considerations.
diff --git a/src/confluent_kafka/src/Admin.c b/src/confluent_kafka/src/Admin.c
index 451017ad6..f198c5404 100644
--- a/src/confluent_kafka/src/Admin.c
+++ b/src/confluent_kafka/src/Admin.c
@@ -5082,7 +5082,7 @@ static void Admin_background_event_cb (rd_kafka_t *rk, rd_kafka_event_t *rkev,
                         PyObject *trace = NULL;
 
                         /* Fetch (and clear) currently raised exception */
-                        PyErr_Fetch(&exctype, &error, &trace);
+                        cfl_exception_fetch(&exctype, &error, &trace);
                         Py_XDECREF(trace);
                 }
 
diff --git a/src/confluent_kafka/src/Consumer.c b/src/confluent_kafka/src/Consumer.c
index 7376c6d84..7dc8bb23d 100644
--- a/src/confluent_kafka/src/Consumer.c
+++ b/src/confluent_kafka/src/Consumer.c
@@ -1575,6 +1575,8 @@ static void Consumer_rebalance_cb (rd_kafka_t *rk, rd_kafka_resp_err_t err,
 		if (result)
 			Py_DECREF(result);
 		else {
+			
+			CallState_fetch_exception(cs);
 			CallState_crash(cs);
 			rd_kafka_yield(rk);
 		}
diff --git a/src/confluent_kafka/src/Producer.c b/src/confluent_kafka/src/Producer.c
index b6a51f510..c1f5bfc4a 100644
--- a/src/confluent_kafka/src/Producer.c
+++ b/src/confluent_kafka/src/Producer.c
@@ -163,6 +163,8 @@ static void dr_msg_cb (rd_kafka_t *rk, const rd_kafka_message_t *rkm,
 	if (result)
 		Py_DECREF(result);
 	else {
+		
+		CallState_fetch_exception(cs);
 		CallState_crash(cs);
 		rd_kafka_yield(rk);
 	}
diff --git a/src/confluent_kafka/src/confluent_kafka.c b/src/confluent_kafka/src/confluent_kafka.c
index bbc335d46..4bdebee14 100644
--- a/src/confluent_kafka/src/confluent_kafka.c
+++ b/src/confluent_kafka/src/confluent_kafka.c
@@ -1755,6 +1755,8 @@ static void error_cb (rd_kafka_t *rk, int err, const char *reason, void *opaque)
 	if (result)
 		Py_DECREF(result);
 	else {
+        
+        CallState_fetch_exception(cs);
         crash:
 		CallState_crash(cs);
 		rd_kafka_yield(h->rk);
@@ -1808,6 +1810,8 @@ static void throttle_cb (rd_kafka_t *rk, const char *broker_name, int32_t broker
                 /* throttle_cb executed successfully */
                 Py_DECREF(result);
                 goto done;
+        } else {
+                CallState_fetch_exception(cs);
         }
 
         /**
@@ -1839,6 +1843,7 @@ static int stats_cb(rd_kafka_t *rk, char *json, size_t json_len, void *opaque) {
 	if (result)
 		Py_DECREF(result);
 	else {
+		CallState_fetch_exception(cs);
 		CallState_crash(cs);
 		rd_kafka_yield(h->rk);
 	}
@@ -1874,6 +1879,7 @@ static void log_cb (const rd_kafka_t *rk, int level,
         if (result)
                 Py_DECREF(result);
         else {
+                CallState_fetch_exception(cs);
                 CallState_crash(cs);
                 rd_kafka_yield(h->rk);
         }
@@ -2572,6 +2578,9 @@ void CallState_begin (Handle *h, CallState *cs) {
 	cs->thread_state = PyEval_SaveThread();
 	assert(cs->thread_state != NULL);
 	cs->crashed = 0;
+	cs->exception_type = NULL;
+	cs->exception_value = NULL;
+	cs->exception_traceback = NULL;
 #ifdef WITH_PY_TSS
         PyThread_tss_set(&h->tlskey, cs);
 #else
@@ -2592,8 +2601,16 @@ int CallState_end (Handle *h, CallState *cs) {
 
 	PyEval_RestoreThread(cs->thread_state);
 
-	if (PyErr_CheckSignals() == -1 || cs->crashed)
+	if (PyErr_CheckSignals() == -1)
+		return 0;
+
+	if (cs->crashed) {
+		/* Restore the saved exception if we have one */
+		if (cs->exception_type) {
+			CallState_restore_exception(cs);
+		}
 		return 0;
+	}
 
 	return 1;
 }
diff --git a/src/confluent_kafka/src/confluent_kafka.h b/src/confluent_kafka/src/confluent_kafka.h
index ac7474c9e..e4b1f3d54 100644
--- a/src/confluent_kafka/src/confluent_kafka.h
+++ b/src/confluent_kafka/src/confluent_kafka.h
@@ -275,8 +275,66 @@ int  Handle_traverse (Handle *h, visitproc visit, void *arg);
 typedef struct {
 	PyThreadState *thread_state;
 	int crashed;   /* Callback crashed */
+	PyObject *exception_type;    /* Stored exception type */
+	PyObject *exception_value;   /* Stored exception value */
+	PyObject *exception_traceback; /* Stored exception traceback */
 } CallState;
 
+/**
+ * @brief Compatibility layer for Python exception handling API changes.
+ * PyErr_Fetch/PyErr_Restore were deprecated in Python 3.12 in favor of 
+ * PyErr_GetRaisedException/PyErr_SetRaisedException.
+ */
+
+static inline void
+cfl_exception_fetch(PyObject **exc_type, PyObject **exc_value, PyObject **exc_traceback) {
+#if PY_VERSION_HEX >= 0x030c0000
+    /* Python 3.12+ - use new API */
+    PyObject *exc = PyErr_GetRaisedException();
+    if (exc) {
+        *exc_type = (PyObject *)Py_TYPE(exc);
+        Py_INCREF(*exc_type);
+        *exc_value = exc;
+        *exc_traceback = PyException_GetTraceback(exc);
+    } else {
+        *exc_type = *exc_value = *exc_traceback = NULL;
+    }
+#else
+    /* Python < 3.12 - use legacy API */
+    PyErr_Fetch(exc_type, exc_value, exc_traceback);
+#endif
+}
+
+static inline void
+cfl_exception_restore(PyObject *exc_type, PyObject *exc_value, PyObject *exc_traceback) {
+#if PY_VERSION_HEX >= 0x030c0000
+    /* Python 3.12+ - use new API */
+    if (exc_value) {
+        PyErr_SetRaisedException(exc_value);
+        Py_XDECREF(exc_type);
+        Py_XDECREF(exc_traceback);
+    }
+#else
+    /* Python < 3.12 - use legacy API */
+    PyErr_Restore(exc_type, exc_value, exc_traceback);
+#endif
+}
+
+static inline void
+CallState_fetch_exception(CallState *cs) {
+    cfl_exception_fetch(&cs->exception_type, &cs->exception_value, &cs->exception_traceback);
+}
+
+static inline void
+CallState_restore_exception(CallState *cs) {
+    if (cs->exception_type) {
+        cfl_exception_restore(cs->exception_type, cs->exception_value, cs->exception_traceback);
+        cs->exception_type = NULL;
+        cs->exception_value = NULL;
+        cs->exception_traceback = NULL;
+    }
+}
+
 /**
  * @brief Initialiase a CallState and unlock the GIL prior to a
  *        possibly blocking external call.
diff --git a/tests/test_Consumer.py b/tests/test_Consumer.py
index bfe03dffc..850fa5ac5 100644
--- a/tests/test_Consumer.py
+++ b/tests/test_Consumer.py
@@ -324,3 +324,38 @@ def test_consumer_without_groupid():
     with pytest.raises(ValueError) as ex:
         TestConsumer({'bootstrap.servers': "mybroker:9092"})
     assert ex.match('group.id must be set')
+
+
+def test_callback_exception_no_system_error():
+
+    exception_raised = []
+
+    def error_cb_that_raises(error):
+        """Error callback that raises an exception"""
+        exception_raised.append(error)
+        raise RuntimeError("Test exception from error_cb")
+
+    # Create consumer with error callback that raises exception
+    consumer = TestConsumer({
+        'group.id': 'test-callback-systemerror-fix',
+        'bootstrap.servers': 'nonexistent-broker:9092',  # Will trigger error
+        'socket.timeout.ms': 100,
+        'session.timeout.ms': 1000,
+        'error_cb': error_cb_that_raises
+    })
+
+    consumer.subscribe(['test-topic'])
+
+    # This should trigger the error callback due to connection failure
+    # Before fix: Would get RuntimeError + SystemError (Issue #865)
+    # After fix: Should only get RuntimeError (no SystemError)
+    with pytest.raises(RuntimeError) as exc_info:
+        consumer.consume(timeout=0.1)
+
+    # Verify we got the expected exception message
+    assert "Test exception from error_cb" in str(exc_info.value)
+
+    # Verify the error callback was actually called
+    assert len(exception_raised) > 0
+
+    consumer.close()
diff --git a/tests/test_Producer.py b/tests/test_Producer.py
index 0f0d69e1d..11049e0a6 100644
--- a/tests/test_Producer.py
+++ b/tests/test_Producer.py
@@ -283,3 +283,34 @@ def test_producer_bool_value():
 
     p = Producer({})
     assert bool(p)
+
+
+def test_callback_exception_no_system_error():
+    delivery_reports = []
+
+    def delivery_cb_that_raises(err, msg):
+        """Delivery report callback that raises an exception"""
+        delivery_reports.append((err, msg))
+        raise RuntimeError("Test exception from delivery_cb")
+
+    producer = Producer({
+        'bootstrap.servers': 'nonexistent-broker:9092',  # Will cause delivery failures
+        'socket.timeout.ms': 100,
+        'message.timeout.ms': 10,  # Very short timeout to trigger delivery failure quickly
+        'on_delivery': delivery_cb_that_raises
+    })
+
+    # Produce a message - this will trigger delivery report callback when it fails
+    producer.produce('test-topic', value='test-message')
+
+    # Flush to ensure delivery reports are processed
+    # Before fix: Would get RuntimeError + SystemError (Issue #865)
+    # After fix: Should only get RuntimeError (no SystemError)
+    with pytest.raises(RuntimeError) as exc_info:
+        producer.flush(timeout=2.0)  # Longer timeout to ensure delivery callback fires
+
+    # Verify we got an exception from our callback
+    assert "Test exception from delivery_cb" in str(exc_info.value)
+
+    # Verify the delivery callback was actually called
+    assert len(delivery_reports) > 0