In wuxia tournaments happen all the time. They can arise for a variety of reasons but often its to resolve leadership issues (for example to see who can be chief of the Wulin) or ownership of an object of importance. Contests can also be a part of the promotion of training process. A major plot point in Demi-gods and Semi-Devils involves a tournament between the major sects.
So in my current campaign the possibility of a tournament between the major martial sects looms large. There is a lot going on and there are a few possible reasons for holding such a contest.
Here are some initial thoughts on how to run a good tournament in the martial world. It is possible I've missed some points or possibilities so readers should feel free to chime in with their own ideas.
The Stakes Should be Real
By real stakes I mean it should be over something that matters and actually affects the campaign. This might be a tournament to unit the sects under one leader for example (or just to help elect the head of a particular sect). Another good reason is control of a significant object, manual or artifact. In our game the Wind Saber of Sunan, which has caused untold havoc as a source of envy and conflict, could potentially be used in this way. A tournament might also be held to secure a coveted position in someone's service. In all these cases, victory means a significant outcome that potentially has a huge impact on the PCs themselves (or at the very least their sect). If the players are going to go to a competition, they won't be too excited if its for the setting's equivalent of a plastic trophy. The competition really needs to be worth their time and effort.
Every tournament needs an organizer. Just anyone can't arrange for the heroes and evils of the martial world to assemble for an organized competition of skill. It has to be someone with the resources or reputation to compel the gathering. Who is it and why are they organizing the event in the first place?
There is a good chance the less orthodox competitors will violate some of these but you will want a list of basic rules of combat. This really can be anything you want though you'll need to address some basic assumptions. Is this to do the death? Are all techniques permissible? How many competitors per match? How long is each match?
Some common ground rules you see in wuxia are things like limiting each match to a set number of strikes or exchanges, disallowing repeated use of the same technique, forbidding lethal force, etc. Some tournaments also have special rules to make things interesting. You could have a competition that only allows kicks or requires computers to drink between rounds. The match might not even be about defeating an opponent, it could be about using your Kung Fu to make the perfect noodle dish, play chess or play keep away.
An Elimination Process
This is about the actual structure of the competition. Whether it is 1 on 1 or team competition, you need to decide how people are eliminated and how they advance. This is going to be very specific to the competition itself. For example you might start with teams, with groups of champions from each sect being selected then having two sects at a time face one another. A given team might only have to beat one or two matches to get to final competition. How many sects are involved will be a big factor here. For instance if you have 8 sects you may have an elimination bracket that looks like the following:
Obviously the only matches you might want to play out live are the ones the PCs are actually taking part in. I personally like to to run the combats separately before the game to know what the outcome will be (if it is too big a task I might eyeball or simplify to a roll off of some kind). However whatever outcomes I have, I assume intervention might change them (for instance if a player decides to poison members of Zhaoze sect because he wants the party to face Sun Mai Temple instead).
You could keep it much simpler too. A common device in wuxia is for the competition to start with one man or woman who takes challengers and the victor of each match remains until no one is willing to step in and fight. This is a pretty straight forward and easy method (though its fairness is debatable).
Ulterior Motives and Politics
Yes there is a competition happening and that's the focus, but it doesn't have to be all that is going on. Maybe the person who organized the tournament did so just to get their hands on something that belongs to one of the other sects (in fact he sent a team to their temple to steal it while they are busy fighting in a silly competition). There may be a wholly unrelated adventure or series of events that unfold and involves the party on the tournament grounds or where they area staying. Perhaps a rival group that wasn't invited shows up to disrupt the event. The point here is to consider the agenda's of the different factions and participants, and make use of them.
A Full Roster
This is the hardest part of planning for a competition. You need to come up with stats for all the NPCs the players may face. If it is relatively small affair, then you may just need a handful of opponents. If it is sizable, then you may need pages of foes. This is probably a good thing anyways because it will help you flesh out your sects with characters you can use again in the future. Since your the GM you have control over how big the scope of the tournament is (unless a PC is organizing it). So make it a size you can tackle.
When you are making lots of different NPCs for a wuxia style game, something I've noticed is they each need to pop and be memorable, just so things don't get too bland. These are all martial heroes with distinct and colorful identities. You might throw in some mooks but for the most part a tournament is going to be focused on people with some amount of skill. Try to mix it up with different weapons, personalities and techniques.