The Hedgehog (Hh) family of secreted proteins governs many developmental processes in both vertebrates and invertebrates. In Drosophila, Hh acts by blocking the formation of a truncated repressor form of Cubitus interruptus (Ci) and by stimulating the nuclear translocation and activity of full-length Ci (Ci155). In the absence of Hh, Ci155 is sequestered in the cytoplasm by forming protein complexes with Costal2 (Cos2), Fused (Fu) and Suppressor of Fused [Su(fu)]. How complex formation regulates Ci155 subcellular localization is not clear. We find that Cos2 interacts with two distinct domains of Ci155, an amino (N)-terminal domain (CDN) and a carboxyl (C)-terminal domain (CORD), and Cos2 competes with Su(fu) for binding to the N-terminal region of Ci155. We provide evidence that both N- and C-terminal Cos2 binding domains are involved in the cytoplasmic retention of Ci155 in imaginal discs. Treating imaginal discs with microtubule-destabilizing reagent nocodazole promotes nuclear translocation of Ci155, suggesting that the microtubule network plays an important role in the cytoplasmic retention of Ci155. In addition, we find that adding a nuclear localization signal (NLS) to exposed regions of Ci155 greatly facilitates its nuclear translocation, suggesting that the cytoplasmic retention of Ci155 may also depend on NLS masking.