The success of ex vivo viral gene therapy systems for promoting bone formation could be improved through the development of systems to spatially localize gene expression. Towards this goal, we have encapsulated adenovirus-transduced human diploid fetal lung fibroblasts (MRC-5) expressing bone morphogenetic protein-type 2 (BMP-2) within non-degradable poly(ethylene glycol)-diacrylate (PEG-DA) hydrogels and implanted these intramuscularly to promote endochondral bone formation. To optimize BMP-2 secretion, the molecular weight of the polymers and cell densities were varied. Polymers with molecular weights of 6, 10, and 20 kDa were used to prepare hydrogels containing 1, 5, or 10 million transduced cells. The results showed that 10 million transduced fibroblasts that was the maximum number of cells feasible for encapsulation within PEG-DA 10 and 20 kDa hydrogels produced the highest amount of secreted BMP-2 protein. Encapsulation of MRC-5 and transduced fibroblasts resulted in 71 and 58% cell viability, respectively. The bioactivity of secreted BMP-2 protein from the hydrogels was confirmed with an alkaline phosphatase assay. Micro-CT of the lower limb muscles of NOD/SCID mice following implantation with hydrogels showed 39.5 +/- 25.0 mm3 mineralized tissue and 31.8 +/- 7.8 mm3 for the cell-injected mice, and the bone was localized to the hydrogel surfaces. Histology revealed bone as well as cartilage for both hydrogel implanted and cell-injected animals.