Telomeres are essential for protecting the ends of chromosomes and preventing chromosome fusion. Telomere loss has been proposed to play an important role in the chromosomal rearrangements associated with tumorigenesis. To determine the relationship between telomere loss and chromosome instability in mammalian cells, we investigated the events resulting from the introduction of a double-strand break near a telomere with I-SceI endonuclease in mouse embryonic stem cells. The inactivation of a selectable marker gene adjacent to a telomere as a result of the I-SceI-induced double-strand break involved either the addition of a telomere at the site of the break or the formation of inverted repeats and large tandem duplications on the end of the chromosome. Nucleotide sequence analysis demonstrated large deletions and little or no complementarity at the recombination sites involved in the formation of the inverted repeats. The formation of inverted repeats was followed by a period of chromosome instability, characterized by amplification of the subtelomeric region, translocation of chromosomal fragments onto the end of the chromosome, and the formation of dicentric chromosomes. Despite this heterogeneity, the rearranged chromosomes eventually acquired telomeres and were stable in most of the cells in the population at the time of analysis. Our observations are consistent with a model in which broken chromosomes that do not regain a telomere undergo sister chromatid fusion involving nonhomologous end joining. Sister chromatid fusion is followed by chromosome instability resulting from breakage-fusion-bridge cycles involving the sister chromatids and rearrangements with other chromosomes. This process results in highly rearranged chromosomes that eventually become stable through the addition of a telomere onto the broken end. We have observed similar events after spontaneous telomere loss in a human tumor cell line, suggesting that chromosome instability resulting from telomere loss plays a role in chromosomal rearrangements associated with tumor cell progression.