Cell signals produced during pancreas embryogenesis regulate pancreatic differentiation. We show that the developing pancreas releases soluble factors responsible for in vitro endocrine pancreatic differentiation from embryonic stem cells (ESCs). A mouse D3 ESC line was transfected with a human insulin promoter/betageo/phosphoglycerate kinase-hygromycin-resistant construct. To direct differentiation, cells were cultured for 7 days to form embryoid bodies and then plated for an additional 7 days. During this 14-day period, besides eliminating leukemia inhibitory factor, cells were cultured in low serum concentration with the addition of conditioned media from embryonic day-16.5 pancreatic buds. Islet cell differentiation was studied by the following: (a) X-gal staining after neomycin selection, (b) BrdU (bro-modeoxyuridine) studies, (c) simple and double immunohistochemistry for insulin, C-peptide, and glucose transporter 2 (Glut-2), (d) reverse transcription-polymerase chain reaction for insulin and pancreas duodenum homeobox 1 (PDX-1), (e) insulin and C-peptide content and secretion assays, (f) intraperitoneal glucose tolerance test, (g) electrophysiology (patch-clamp studies in inside-out configuration), and (h) transplantation of differentiated cells under the kidney capsule of streptozotocin-diabetic mice. The differentiated ESCs showed the following: changes in the mRNA levels of insulin and PDX-1; coexpression of insulin, C-peptide, and Glut-2; glucose and tolbutamide-dependent insulin and C-peptide release; K-channel activity regulated by ATP; and normalization of blood glucose levels after transplantation into diabetic mice and hyperglycemia after graft removal. In this study, we establish a battery of techniques that could be used together to properly characterize islet cell differentiation. Moreover, identification of factors released by the developing pancreas may be instrumental in engineering beta cells from stem cells.