(FORTUNE Small Business) – Bonny Dutton just wanted to stick to her knitting. The single mother of a 2-year-old boy, Dutton (right), 42, runs a children's apparel business called Fleece on Earth from a barn behind her home in Chittenden, Vt. She pays local retirees to knit baby bonnets and sweaters, which she sells at craft fairs and online.

For Dutton, "Made in Vermont" was more than just a marketing tool; it was a point of pride--until she tangled with the state's Department of Labor in 2003. That was when one of her knitters filed for unemployment after losing an unrelated job. State investigators decided the knitter was an employee of Fleece on Earth and slapped the company with a bill for $1,000 in unpaid unemployment insurance and penalties. Dutton filed suit against the state, arguing that her knitters were not employees but independent contractors working out of their homes.

As more firms use contractors to cut costs, the legal definition of "employee" could be critical. Once a worker is dubbed an employee, labor costs increase significantly. As for Dutton, she is fighting to preserve the integrity of her company. "I want to keep things local," she says. "I like working with my neighbors, but if it suits my business, I might have to move production to China."