Hedgehog (Hh) signaling, via the key signal transducer Smoothened (SMO) and Gli transcription factors, is essential for embryonic development and carcinogenesis. At present, the molecular mechanism of Hh signaling-mediated carcinogenesis is not completely understood. Using a mouse model (K14cre/R26SmoM2) of SMO-mediated basal cell carcinoma development, we identified TGFβ2 as a major Hh-regulated gene. TGFβ2 expression was high in the keratinocytes, with activated TGFβ signaling (indicated by elevated expression of phosphorylated SMAD2/3) detected in both tumor and stroma. The significance of TGFβ signaling for SMO function was demonstrated in two assays. Down-regulation of TGFβ2 expression prevented Hh signaling-dependent osteoblast differentiation and motor neuron differentiation. Furthermore, inhibition of TGFβ signaling by TGFβ receptor I inhibitor SD208 significantly reduced tumor area in K14cre/R26SmoM2 mice. Tumor shrinkage in mice was associated with an increased number of lymphocytes, suggesting an immune suppression role of TGFβ signaling. The relevance of our results to human cancer is reflected by the fact that human basal cell carcinomas, which almost always harbor activated Hh signaling, have activated TGFβ signaling, as indicated by high levels of phosphorylated SMAD2 and SMAD3 in tumor and stroma. Together, our data indicate that TGFβ signaling is critical for Hh signaling-mediated carcinogenesis.