Bone regenerates by activation of tissue resident stem/progenitor cells, formation of a fibrous callus followed by deposition of cartilage and bone matrices. Here, we show that mesenchymal progenitors residing in skeletal muscle adjacent to bone mediate the initial fibrotic response to bone injury and also participate in cartilage and bone formation. Combined lineage and single-cell RNA sequencing analyses reveal that skeletal muscle mesenchymal progenitors adopt a fibrogenic fate before they engage in chondrogenesis after fracture. In polytrauma, where bone and skeletal muscle are injured, skeletal muscle mesenchymal progenitors exhibit altered fibrogenesis and chondrogenesis. This leads to impaired bone healing, which is due to accumulation of fibrotic tissue originating from skeletal muscle and can be corrected by the anti-fibrotic agent Imatinib. These results elucidate the central role of skeletal muscle in bone regeneration and provide evidence that skeletal muscle can be targeted to prevent persistent callus fibrosis and improve bone healing after musculoskeletal trauma.