In this study, a microgel composed of chitosan and inorganic phosphates was used to deliver poly(lactic-co-glycolic acid) (PLAGA) microspheres loaded with sphingolipid growth factor FTY720 to critical size cranial defects in Sprague Dawley rats. We show that sustained release of FTY720 from injected microspheres used alone or in combination with recombinant human bone morphogenic protein-2 (rhBMP2) improves defect vascularization and bone formation in the presence and absence of rhBMP2 as evaluated by quantitative microCT and histological measurements. Moreover, sustained delivery of FTY720 from PLAGA and local targeting of sphingosine 1-phosphate (S1P) receptors reduces CD45+ inflammatory cell infiltration, promotes endogenous recruitment of CD29+CD90+ bone progenitor cells and enhances the efficacy of rhBMP2 from chitosan microgels. Companion in vitro studies suggest that selective activation of sphingosine receptor subtype-3 (S1P3) via FTY720 treatment induces smad-1 phosphorylation in bone-marrow stromal cells. Additionally, FTY720 enhances stromal cell-derived factor-1 (SDF-1) mediated chemotaxis of CD90+CD11B-CD45- bone progenitor cells in vitro after stimulation with rhBMP2. We believe that use of such small molecule delivery formulations to recruit endogenous bone progenitors may be an attractive alternative to exogenous cell-based therapy.