Bone morphogenetic protein 2 (BMP-2) plays a critical role in osteoblast function. In Drosophila, Cubitus interruptus (Ci), which mediates hedgehog signaling, regulates gene expression of dpp, the ortholog of mammalian BMP-2. Null mutation of the transcription factor Gli2, a mammalian homolog of Ci, results in severe skeletal abnormalities in mice. We hypothesize that Gli2 regulates BMP-2 gene transcription and thus osteoblast differentiation. In the present study, we show that overexpression of Gli2 enhances BMP-2 promoter activity and mRNA expression in osteoblast precursor cells. In contrast, knocking down Gli2 expression by Gli2 small interfering RNA or genetic ablation of the Gli2 gene results in significant inhibition of BMP-2 gene expression in osteoblasts. Promoter analyses, including chromatin immunoprecipitation and electrophoretic mobility shift assays, provided direct evidence that Gli2 physically interacts with the BMP-2 promoter. Functional studies showed that Gli2 is required for osteoblast maturation in a BMP-2-dependent manner. Finally, Sonic hedgehog (Shh) stimulates BMP-2 promoter activity and osteoblast differentiation, and the effects of Shh are mediated by Gli2. Taken together, these results indicate that Gli2 mediates hedgehog signaling in osteoblasts and is a powerful activator of BMP-2 gene expression, which is required in turn for normal osteoblast differentiation.