Shortage of cadaveric pancreata and requirement of immune suppression are two major obstacles in transplantation therapy of type 1 diabetes. Here, we investigate whether i.p. transplantation of alginate-encapsulated insulin-producing cells from the embryo-derived mouse embryo progenitor-derived insulin-producing-1 (MEPI-1) line could lower hyperglycemia in immune-competent, allogeneic diabetic mice. Within days after transplantation, hyperglycemia was reversed followed by about 2.5 months of normo- to moderate hypoglycemia before relapsing. Mice transplanted with unencapsulated MEPI cells relapsed within 2 weeks. Removal of the transplanted capsules by washing of the peritoneal cavity caused an immediate relapse of hyperglycemia that could be reversed with a second transplantation. The removed capsules had fibrotic overgrowth but remained permeable to 70 kDa dextrans and displayed glucose-stimulated insulin secretion. Following transplantation, the number of cells in capsules increased initially, before decreasing to below the starting cell number at 75 days. Histological examination showed that beyond day 40 post-transplantation, encapsulated cell clusters exhibited proliferating cells with a necrotic core. Blood glucose, insulin levels, and oral glucose tolerance test in the transplanted animals correlated directly with the number of viable cells remaining in the capsules. Our study demonstrated that encapsulation could effectively protect MEPI cells from the host immune system without compromising their ability to correct hyperglycemia in immune-competent diabetic mice for 2.5 months, thereby providing proof that immunoisolation of expansible but immune-incompatible stem cell-derived surrogate β-cells by encapsulation is a viable diabetes therapy.