Fibroblast growth factors and receptors are intimately connected to the extracellular matrix by their affinity to heparan sulfate proteoglycans. They mediate multiple processes during embryonic development and adult life. In this study, embryonic stem cell-derived embryoid bodies were used to model fibroblast growth factor signaling during early epithelial morphogenesis. To avoid redundancy caused by multiple receptors, we employed a dominant negative mutation of Fgfr2. Mutant-derived embryoid bodies failed to form endoderm, ectoderm, and basement membrane and did not cavitate. However, in mixed cultures they displayed complete differentiation induced by extracellular products of the normal cell. Evidence will be presented here that at least one of these products is the basement membrane or factors connected to it. It will be shown that in the mutant, collagen IV and laminin-1 synthesis is coordinately suppressed. We will demonstrate that the basement membrane is required for embryoid body differentiation by rescuing columnar ectoderm differentiation and cavitation in the mutant by externally added basement membrane proteins. This treatment induced transcription of Eomesodermin, an early developmental gene, suggesting that purified basement membrane proteins can activate inherent developmental programs. Our results provide a new paradigm for the role of fibroblast growth factor signaling in basement membrane formation and epithelial differentiation.