We have identified a model system for the study of pancreatic islet development and regeneration in transgenic mice bearing the interferon-gamma (IFN-g) gene expressed in the pancreatic islets. Previous studies showed that the locally produced IFN-g causes lymphocyte infiltration and islet cell destruction. Here we demonstrate that new islet cells are formed continuously from duct cells as evidenced by (1) the dramatic proliferation of duct cells, (2) the appearance of primitive cells and (3) their subsequent differentiation to endocrine cells. The IFN-g induced islet neogenesis is similar to embryonic islet morphogenesis and offers a model system for studying factors modulating islet development. Additionally, the duct cells occasionally transdifferentiate to gastrointestinal-like cell types and hepatocytes. These results underscore the lymphokine's ability to initiate a complex 'transdifferentiation' pathway, providing a window for understanding lineage interrelationships within a terminally differentiated structure.