The mammalian pancreas is a specialized derivative of the primitive gut endoderm and controls many homeostatic functions through the activity of its component exocrine acinar and endocrine islet cells. The LIM homeodomain protein ISL1 is expressed in all classes of islet cells in the adult and its expression in the embryo is initiated soon after the islet cells have left the cell cycle. ISL1 is also expressed in mesenchymal cells that surround the dorsal but not ventral evagination of the gut endoderm, which together comprise the pancreatic anlagen. To define the role of ISL1 in the development of the pancreas, we have now analysed acinar and islet cell differentiation in mice deficient in ISL1 function. Dorsal pancreatic mesenchyme does not form in ISL1-mutant embryos and there is an associated failure of exocrine cell differentiation in the dorsal but not the ventral pancreas. There is also a complete loss of differentiated islet cells. Exocrine, but not endocrine, cell differentiation in the dorsal pancreas can be rescued in vitro by provision of mesenchyme derived from wild-type embryos. These results indicate that ISL1, by virtue of its requirement for the formation of dorsal mesenchyme, is necessary for the development of the dorsal exocrine pancreas, and also that ISL1 function in pancreatic endodermal cells is required for the generation of all endocrine islet cells.