A DNA fragment carrying the genes coding for a novel EcoT38I restriction endonuclease (R.EcoT38I) and EcoT38I methyltransferase (M.EcoT38I), which recognize G(A/G)GC(C/T)C, was cloned from the chromosomal DNA of Escherichia coli TH38. The endonuclease and methyltransferase genes were in a head-to-head orientation and were separated by a 330-nucleotide intergenic region. A third gene, the C.EcoT38I gene, was found in the intergenic region, partially overlapping the R.EcoT38I gene. The gene product, C.EcoT38I, acted as both a positive regulator of R.EcoT38I gene expression and a negative regulator of M.EcoT38I gene expression. M.EcoT38I purified from recombinant E. coli cells was shown to be a monomeric protein and to methylate the inner cytosines in the recognition sequence. R.EcoT38I was purified from E. coli HB101 expressing M.EcoT38I and formed a homodimer. The EcoT38I restriction (R)-modification (M) system (R-M system) was found to be inserted between the A and Q genes of defective bacteriophage P2, which was lysogenized in the chromosome at locI, one of the P2 phage attachment sites observed in both E. coli K-12 MG1655 and TH38 chromosomal DNAs. Ten strains of E. coli TH38 were examined for the presence of the EcoT38I R-M gene on the P2 prophage. Conventional PCR analysis and assaying of R activity demonstrated that all strains carried a single copy of the EcoT38I R-M gene and expressed R activity but that diversity of excision in the ogr, D, H, I, and J genes in the defective P2 prophage had arisen.