Gli family zinc finger proteins are mediators of Sonic hedgehog (Shh) signaling in vertebrates. The question remains unanswered, however, as to how these Gli proteins participate in the Shh signaling pathway. In this study, regulatory activities associated with the Gli2 protein were investigated in relation to the Shh signaling. Although Gli2 acts as a weak transcriptional activator, it is in fact a composite of positive and negative regulatory domains. In cultured cells, truncation of the activation domain in the C-terminal half results in a protein with repressor activity, while removal of the repression domain at the N terminus converts Gli2 into a strong activator. In transgenic mouse embryos, N-terminally truncated Gli2, unlike the full length protein, activates a Shh target gene, HNF3beta, in the dorsal neural tube, thus mimicking the effect of Shh signal. This suggests that unmasking of the strong activation potential of Gli2 through modulation of the N-terminal repression domain is one of the key mechanisms of the Shh signaling. A similar regulatory mechanism involving the N-terminal region was also found for Gli3, but not for Gli1. When the Shh signal derived from the notochord is received by the neural plate, the widely expressed Gli2 and Gli3 proteins are presumably converted to their active forms in the ventral cells, leading to activation of transcription of their target genes, including Gli1.