Several lines of evidence implicate zinc finger proteins of the Gli family in the final steps of Hedgehog signaling in normal development and disease. C-terminally truncated mutant GLI3 proteins are also associated with human syndromes, but it is not clear whether these C-terminally truncated Gli proteins fulfil the same function as full-length ones. Here, structure-function analyses of Gli proteins have been performed using floor plate and neuronal induction assays in frog embryos, as well as induction of alkaline phosphatase (AP) in SHH-responsive mouse C3H10T1/2 (10T1/2) cells. These assays show that C-terminal sequences are required for positive inducing activity and cytoplasmic localization, whereas N-terminal sequences determine dominant negative function and nuclear localization. Analyses of nuclear targeted Gli1 and Gli2 proteins suggest that both activator and dominant negative proteins are modified forms. In embryos and COS cells, tagged Gli cDNAs yield C-terminally deleted forms similar to that of Ci. These results thus provide a molecular basis for the human Polydactyly type A and Pallister-Hall Syndrome phenotypes, derived from the deregulated production of C-terminally truncated GLI3 proteins. Analyses of full-length Gli function in 10T1/2 cells suggest that nuclear localization of activating forms is a regulated event and show that only Gli1 mimics SHH in inducing AP activity. Moreover, full-length Gli3 and all C-terminally truncated forms act antagonistically whereas Gli2 is inactive in this assay. In 10T1/2 cells, protein kinase A (PKA), a known inhibitor of Hh signaling, promotes Gli3 repressor formation and inhibits Gli1 function. Together, these findings suggest a context-dependent functional divergence of Gli protein function, in which a cell represses Gli3 and activates Gli1/2 prevents the formation of repressor Gli forms to respond to Shh. Interpretation of Hh signals by Gli proteins therefore appears to involve a fine balance of divergent functions within each and among different Gli proteins, the misregulation of which has profound biological consequences.