This will be an unpopular view, but I would suggest the biggest blunder is a failure to exploit Japan's peace offers prior to 1938. Remember that Imperial Japan was wracked with internal conflicts and factionalism, and that its establishment historically viewed the Soviet Union as its primary enemy. When the war in China broke out, significant voices in the civil government and military high command sought to keep the conflict limited.
The most well known part of their efforts is the Trautmann mediation. On 2 November 1937, Japan asked the German ambassador Trautmann to transmit some relatively lenient peace terms:
- China to join the Anti-Comintern Pact
- Break off relations with the Soviet Union
- Put an end to the Chinese anti-Japan movement
- Autonomy for Inner Monolia
- Demilitarisation Zone on border with Manchukuo and in Shanghai
This initial offer was rejected immediately. At this stage, Japanese High Command had no plans to move on Nanking. On 7 November, the Army General Staff issued an order limiting operations in the theatre to a line east of Suzhou and Jiaxing. This order was subsequently disregarded by Japanese units on the ground on 19 November. The Japanese government then repeated its previous peace terms on 22 November.
This time Chiang held a high level meeting of the Chinese government, which concluded that, with no demand for reparations or recognition of Manchukuo, the terms were actually acceptable. Chinese acceptance was transmitted to Trauntmann on 2 December for relaying to Japan - by which point, Japanese forces were on the verge of capturing Nanking.
With the fall of Nanking, initiative within the Japanese government had passed completely into the hands of the hawks. The list of demands were amended to include an unspecified amount of reparations as well as a unified anti-communism front that now includes Manchukuo - that is to say, Japan now demanded Chinese recognition of Manchukuo.
These terms were considered beyond the pale by the Chinese government. With Japanese doves cowed and open talk of using the truce to rearm by Chinese notables, the peace effort fell apart.
The failure of the Trauntmann mediation led Germany to completely abandon China as an ally. Apart from economic/industrial aid, the more immediately important shipments of military supplies and arms were halted, and German military advisors were ordered to leave. Those were substantial losses China was ill equipped to replace herself - and in 1938, China needed every little scrap of anything it could possibly get.
On the other hand, although long lasting peace was unsustainable (probably), a temporary truce in 1937 would still have benefited China immensely. The German trained and equipped elite Chinese forces, freshly eviscerated on the bloody streets of Shanghai, would have had time to rebuild and expand. Chinese industrial expansion could have been undertaken, and relocating them to the interior would not have had to be achieved with massive sacrifices under enemy fire.
EDIT: A note on the political feasibility of a truce with Japan. While not exactly a populist strategy, it wasn't unacceptable to China at large either. I think this can be illustrated into two incidents where non-Chiang-aligned, regional cliques rebelled (purportedly to fight the Japanese): the Liangkwang Incident, and the rather more successful/famous Xi'an Incident.
The Liangkwang Incident began on June 1, 1936. The Guangdong and Guangxi cliques telegraphed a denouncement of Chiang's central government over "inaction" against Japanese imperialism. They then announced that their forces were moving into Hunan.
But by June 10 the central government's forces had blocked the cliques' armies, and Hunan's regional government sided with the Nationalist government. Not long thereafter, Cantonese generals led by Yu Han-Mou pledged loyalty to the central government and moved against their former comrades, who retreated without putting up a fight. Then the entirety of the Cantonese air force took off and defected, followed by the rest of the Guangdong clique's army.
The Guanxi clique fared rather more successfully, maintaining internal cohesion until September, when the Guanxi clique resubmitted to Chiang in exchange for the central government's agreement to cease encroaching upon their territory. But nonetheless the cliques, contrary to their anti-Japan slogans, were ultimately motivated by regional political interests. More to the point, the basis of Chiang's power was not much shaken by having to fight against an anti-Japan faction.
The Xi'an incident provides an indicator of contemporary public opinion. Not only did the central government continue to support Chiang after his capture during the "armed remonstrance", the mutineers were widely condemned in the court of public opinion.
On December 13, members of Nanking's universities including professor Lo Chia-Luen telegraphed their condemnations to Chang Hsueh Liang. The Peking and Shanghai universities (Mei I-chi, Chiang Monlin, Herman Liu) followed on December 14. The next day, over a hundred newspaper publishers published a joint declaration decrying the Fengtian Clique's actions. On December 16, more than two hundred magazines issued a similar condemnation. And on the same day the Tsing Hua University transmitted their denouncement of Chang's "rebellion", drafted by among others Wen I-To. The influential Ta Kung Pao published Hu Shih's "The Treason of Chang Hsueh Liang" on Dec 20, denouncing Chang and voicing support for maintaining peace to strengthen China.
Much of the intellectual elites of China (many of whom were themselves well acquainted with Japanese modernisation) recognised the lopsided military balance. Chang's actions in initiating the Xi'an Incident were widely lambasted as using the guise of resisting that Japanese to destroy national unity and strength. Chinese intellectuals at the time were inevitably aware of how the previous ethnic Chinese regime, the Ming Dynasty, fell to a war on two fronts - internal and external - against Manchuria. And the slogan of pacify the nation to resist foreigners has had a long tradition dating back to the Spring and Autumn period (as the term later borrowed into Japan as Sonnō Jōi).
Add in the fact that warlords were primarily concerned with their personal powers, then it would seem the biggest voice against compromise would be that of the common folk. I'm not sure that, in an impoverished China ruled by warlords, their voices carry much political weight.