Understanding effects of chronic nicotine requires identifying the neurons and synapses whose responses to nicotine itself, and to endogenous acetylcholine, are altered by continued exposure to the drug. To address this problem, we developed mice whose alpha4 nicotinic receptor subunits are replaced by normally functioning fluorescently tagged subunits, providing quantitative studies of receptor regulation at micrometer resolution. Chronic nicotine increased alpha4 fluorescence in several regions; among these, midbrain and hippocampus were assessed functionally. Although the midbrain dopaminergic system dominates reward pathways, chronic nicotine does not change alpha4* receptor levels in dopaminergic neurons of ventral tegmental area (VTA) or substantia nigra pars compacta. Instead, upregulated, functional alpha4* receptors localize to the GABAergic neurons of the VTA and substantia nigra pars reticulata. In consequence, GABAergic neurons from chronically nicotine-treated mice have a higher basal firing rate and respond more strongly to nicotine; because of the resulting increased inhibition, dopaminergic neurons have lower basal firing and decreased response to nicotine. In hippocampus, chronic exposure to nicotine also increases alpha4* fluorescence on glutamatergic axons of the medial perforant path. In hippocampal slices from chronically treated animals, acute exposure to nicotine during tetanic stimuli enhances induction of long-term potentiation in the medial perforant path, showing that the upregulated alpha4* receptors in this pathway are also functional. The pattern of cell-specific upregulation of functional alpha4* receptors therefore provides a possible explanation for two effects of chronic nicotine: sensitization of synaptic transmission in forebrain and tolerance of dopaminergic neuron firing in midbrain.