The administration of mesenchymal stem cells (MSCs) was shown to attenuate overt as well as early diabetic nephropathy in rodents, but the underlying mechanism of this beneficial effect is largely unknown. Inflammation and mitochondrial dysfunction are major pathogenic factors in diabetic nephropathy. In this study, we found that the repeated administration of MSCs prevents albuminuria and injury to tubular epithelial cells (TECs), an important element in the progression of diabetic nephropathy, by improving mitochondrial function. The expression of M1 macrophage markers was significantly increased in diabetic kidneys compared with that in control kidneys. Interestingly, the expression of arginase-1 (Arg1), an important M2 macrophage marker, was reduced in diabetic kidneys and increased by MSC treatment. In cultured TECs, conditioned media from lipopolysaccharide-activated macrophages reduced peroxisomal proliferator-activated receptor gamma coactivator 1α (Pgc1a) expression and impaired mitochondrial function. The coculture of macrophages with MSCs increased and decreased the expression of Arg1 and M1 markers, respectively. Treatment with conditioned media from cocultured macrophages prevented activated macrophage-induced mitochondrial dysfunction in TECs. In the absence of MSC coculture, Arg1 overexpression in macrophages reversed Pgc1a suppression in TECs. These observations suggest that MSCs prevent the progression of diabetic nephropathy by reversing mitochondrial dysfunction in TECs via the induction of Arg1 in macrophages.