Bidirectional signaling triggered by interacting ephrinB receptors (EphB) and ephrinB ligands is crucial for development and function of the vascular and nervous systems. A signaling cascade triggered by this interaction involves activation of Src kinase and phosphorylation of ephrinB. The mechanism, however, by which EphB activates Src in the ephrinB-expressing cells is unknown. Here we show that EphB stimulates a metalloproteinase cleavage of ephrinB2, producing a carboxy-terminal fragment that is further processed by PS1/gamma-secretase to produce intracellular peptide ephrinB2/CTF2. This peptide binds Src and inhibits its association with inhibitory kinase Csk, allowing autophosphorylation of Src at residue tyr418. EphrinB2/CTF2-activated Src phosphorylates ephrinB2 and inhibits its processing by gamma-secretase. These data show that the PS1/gamma-secretase system controls Src activation and ephrinB phosphorylation by regulating production of Src activator ephrinB2/CTF2. Accordingly, gamma-secretase inhibitors prevented the EphB-induced sprouting of endothelial cells and the recruitment of Grb4 to ephrinB. PS1 FAD and gamma-secretase dominant-negative mutants inhibited the EphB-induced cleavage of ephrinB2 and Src autophosphorylation, raising the possibility that FAD mutants interfere with the functions of Src and ephrinB2 in the CNS.