Optical many-body systems naturally possess strong light-matter interactions and are thus of central importance for photonic applications. However, these applications are so far limited within the regime of intrinsic dynamically stable phases, and the possibility of unstable phases remains unidentified. Here we experimentally revealed a new dynamical phase of intrinsic optical instability by using a continuous-wave laser to drive an erbium-doped crystal. The transmission through the sample became unstable for intense laser inputs, and transient net gain was observed if the light passed the sample twice. The phase transition, between states in and out of a dynamical equilibrium, was induced by the dipole-dipole interactions between nearby erbium ions.