The hedgehog (Hh) signaling pathway plays fundamental roles during embryonic development and tumorigenesis. Previously, we have shown that ablation of the tumor suppressor and negative regulator, Suppressor of fused (Sufu), within this pathway causes embryonic lethality around E9.5 in the mouse. In this study, we examine how lack of Sufu influences early cell fate determination processes. We established embryonic stem cell (ESC) lines from preimplantation Sufu(-/-) and wild-type mouse embryos and show that these ESCs express the typical pluripotency markers, alkaline phosphatase, SSEA-1, Oct4, Sox2, and Nanog. We demonstrate that these ESCs express all core Hh pathway components and that glioma-associated protein (Gli)1 mRNA levels are increased in Sufu(-/-) ESCs. Upon spontaneous differentiation of Sufu(-/-) ESCs into embryoid bodies (EBs) in vitro, the Hh pathway is strongly upregulated as indicated by an increase in both Gli1 and patched1 (Ptch1) gene expression. Interestingly, developing Sufu(-/-) EBs were smaller than their wild-type counterparts and showed decreased expression of the ectodermal markers, Fgf5 and Sox1. In vivo teratoma formation revealed that Sufu(-/-) ESCs have a limited capacity for differentiation as the resulting tumors lacked the mesodermal derivatives, cartilage and bone. However, Sufu(-/-) ESCs were able to develop into chondrocytes and osteocytes in vitro, which suggests a differential response of ESCs compared with in vivo conditions. Our findings suggest a regulatory function of the Hh signaling pathway in early mesodermal cell fate determination and emphasize the role of Sufu as a key molecule in this process.