Blood islands, the precursors of yolk sac blood vessels, contain primitive erythrocytes surrounded by a layer of endothelial cells. These structures differentiate from extra-embryonic mesodermal cells that underlie the visceral endoderm. Our previous studies have shown that Indian hedgehog (Ihh) is expressed in the visceral endoderm both in the visceral yolk sac in vivo and in embryonic stem (ES) cell-derived embryoid bodies. Differentiating embryoid bodies form blood islands, providing an in vitro model for studying vasculogenesis and hematopoiesis. A role for Ihh in yolk sac function is suggested by the observation that roughly 50% of Ihh(-/-) mice die at mid-gestation, potentially owing to vascular defects in the yolk sac. To address the nature of the possible vascular defects, we have examined the ability of ES cells deficient for Ihh or smoothened (Smo), which encodes a receptor component essential for all hedgehog signaling, to form blood islands in vitro. Embryoid bodies derived from these cell lines are unable to form blood islands, and express reduced levels of both PECAM1, an endothelial cell marker, and alpha-SMA, a vascular smooth muscle marker. RT-PCR analysis in the Ihh(-/-) lines shows a substantial decrease in the expression of Flk1 and Tal1, markers for the hemangioblast, the precursor of both blood and endothelial cells, as well as Flt1, an angiogenesis marker. To extend these observations, we have examined the phenotypes of embryo yolk sacs deficient for Ihh or SMO: Whereas Ihh(-/-) yolk sacs can form blood vessels, the vessels are fewer in number and smaller, perhaps owing to their inability to undergo vascular remodeling. Smo(-/-) yolk sacs arrest at an earlier stage: the endothelial tubes are packed with hematopoietic cells, and fail to undergo even the limited vascular remodeling observed in the Ihh(-/-) yolk sacs. Our study supports a role for hedgehog signaling in yolk sac angiogenesis.