Following a failed impeachment of President Ranasinghe Premadasa, he was removed from the UNP and formed his own party, the Democratic United National Front.

S. W. R. D. Bandaranaike, the prime minister at the time and a close friend of his late father, on hearing his case, provided him with a Ceylon Government Scholarship having passed it through parliament.

During this time, as Minister of Trade, he introduced Intellectual Property Law; established the Sri Lanka Export Development Board and the Ports Authority.

He established the Mahapola Trust Fund in 1981 to provision of financial assistance to students undertaking higher education.

[4] He organised several offensives against territories held by the LTTE including the Vadamarachchi Operation and was apposed to the Indo-Sri Lanka Accord.

The main brokers of the so-called truce were a lawyer called Kelly Senanayake and Fr Thissa Balasooriya who later found had no mandate to represent JVP.

His status in government changed upon Jayewardene's retirement in 1988, he tried to obtain the UNP's nomination for the presidential election, but was defeated by Ranasinghe Premadasa who went on to win the presidency.

Premadasa retained Athulathmudali in his cabinet, but demoted him by appointing him as Minister of Agriculture, Food and Cooperatives.

Premadasa tried to have Athulathmudali removed from his UNP party positions and accused him of being one of the cabinet ministers behind the Burning of Jaffna library in 1981.

Athulathmudali resigned his cabinet position in August 1991 and in September 1991 he and several UNP MPs brought forth a motion to impeach Premadasa.

Athulathmudali together with Dissanayake formed a new party, the Democratic United National Front with both serving as joint president in November 1991.

Under the DUNF, Athulathmudali handed over his papers to contest the 1993 Provincial elections seeking the chief ministership of the Western Province Council.

A body of a youth named Ragunathan alias Appiah Balakrishnan, a member of the LTTE was found near the scene (down Mugalan road).

The Lalith Athulathmudali Auditorium at the Sri Lanka Institute of Information Technology and the Lalith Athulathmudali Memorial Prize which is one of the prestigious prizes awarded annually at Royal College, Colombo (his alma mater) (awarded for the Most Outstanding Royalist (Student of Royal College) of the Year are named in his honour.