Type II alveolar epithelial (AT-II) cells produce pulmonary surfactant proteins that are essential for alveolar function. AT-II is a major target in lung injury, and ineffective repair of damaged alveolar epithelia has been postulated to cause pulmonary fibrosis. Previous studies have shown that tyrosine phosphatase Shp2 is expressed highly in the embryonic lung epithelial buds, and Shp2 activity is required for FGF-induced lung branching morphogenesis. To investigate in vivo function of pulmonary Shp2, we generated alveoli epithelia-specific Shp2-knockout (Shp2(Δ/Δ)) mice. Shp2(Δ/Δ) mice exhibit marked reduction in surfactant proteins, disorganized lamellar bodies, increased alveolar epithelial apoptosis, and interstitial pulmonary fibrosis without preceding inflammation. Mechanistically, Shp2 acts to mediate expression of thyroid transcription factor 1 (TTF1) and ATP-binding cassette subfamily A member 3 (ABCA3). Shp2 also plays a central role in mediating FGF/GAB/ERK activity, required for epithelial repair program. Together, our results identify a novel role of tyrosine phosphatase Shp2 in surfactant homeostasis, and deregulation of Shp2 triggers spontaneous pulmonary fibrosis with minimal inflammation.