The protein-tyrosine phosphatase SHP-1 is a negative regulator of multiple signal transduction pathways. We observed that SHP-1 effectively antagonized Src-dependent phosphorylations in HEK293 cells. This occurred by dephosphorylation of Src substrates, because Src activity was unaffected in the presence of SHP-1. One reason for efficient dephosphorylation was activation of SHP-1 by Src. Recombinant SHP-1 had elevated activity subsequent to phosphorylation by Src in vitro, and SHP-1 variants with mutated phosphorylation sites in the C terminus, SHP-1 Y538F, and SHP-1 Y538F,Y566F were less active toward Src-generated phosphoproteins in intact cells. A second reason for efficient dephosphorylation is the substrate selectivity of SHP-1. Pull-down experiments with different GST-SHP-1 fusion proteins revealed efficient interaction of Src-generated phosphoproteins with the SHP-1 catalytic domain rather than with the SH2 domains. Phosphopeptides that correspond to good Src substrates were efficiently dephosphorylated by SHP-1 in vitro. Phosphorylated "optimal Src substrate" AEEEIpYGEFEA (where pY is phosphotyrosine) and a phosphopeptide corresponding to a recently identified Src phosphorylation site in p120 catenin, DDLDpY(296)GMMSD, were excellent SHP-1 substrates. Docking of these phosphopeptides into the catalytic domain of SHP-1 by molecular modeling was consistent with the biochemical data and explains the efficient interaction. Acidic residues N-terminal of the phosphotyrosine seem to be of major importance for efficient substrate interaction. Residues C-terminal of the phosphotyrosine probably contribute to the substrate selectivity of SHP-1. We propose that activation of SHP-1 by Src and complementary substrate specificities of SHP-1 and Src may lead to very transient Src signals in the presence of SHP-1.