The Pd-catalyzed allylic alkylation of 3,4-disubstituted, racemic cyclobutene electrophiles exhibits a highly unusual stereoselectivity that allows for controlling diastereo- and enantioselectivity only by the choice of ligand and independent of the configuration of the substrate. In order to shed light on the origin of stereoinduction, we performed a systematic mechanistic investigation, including preparation of various putative Pd-allyl intermediates, 1H/31P NMR reaction monitoring, 2H-labeling studies, ESI-HRMS and 31P NMR analysis of reaction mixtures, and DFT structural computations. The mechanism disclosed exhibits several steps with stereospecificities deviating from the commonly accepted "double inversion rule": oxidative addition was found to follow a stereoconvergent course, giving anti-configured η1-Pd-cyclobutene species as detectable on-cycle intermediates irrespective of the configuration of starting material, while the subsequent nucleophilic attack features a stereodivergent behavior. In stark contrast to their highly reactive anti-analogues, syn-Pd-cyclobutene complexes that can be formed as side products are rendered entirely unreactive by strong internal Pd-O chelation, preventing the formation of undesired product diastereomers.