The Drosophila gypsy retrotransposon disrupts gene activity by blocking the interactions of distal enhancers with target promoters. This enhancer-blocking activity is mediated by a 340 bp insulator DNA within gypsy. The insulator contains a cluster of binding sites for a zinc finger protein, suppressor of Hairy wing [su(Hw)]. Recent studies have shown that a second protein, mod(mdg4), is also important for normal insulator function. Mutations in mod(mdg4) exert paradoxical effects on different gypsy-induced phenotypes. For example, it enhances yellow2 but suppresses cut6. Here, we employ a stripe expression assay in transgenic embryos to investigate the role of mod(mdg4) in gypsy insulator activity. The insulator was inserted between defined enhancers and placed among divergently transcribed reporter genes (white and lacZ) containing distinct core promoter sequences. These assays indicate that mod(mdg4) is essential for the enhancer-blocking activity of the insulator DNA. Moreover, reductions in mod(mdg4)+ activity cause the insulator to function as a promoter-specific silencer that selectively represses white, but not lacZ. The repression of white does not affect the expression of the closely linked lacZ gene, suggesting that the insulator does not propagate changes in chromatin structure. These results provide an explanation for why mod(mdg4) exerts differential effects on different gypsy-induced mutations.