Patterning of the early neural tube is achieved in part by the inductive signals, which arise from neuroepithelial signaling centers. The zona limitans intrathalamica (ZLI) is a neuroepithelial domain in the alar plate of the diencephalon which separates the prethalamus from the thalamus. The ZLI has recently been considered to be a possible secondary organizer, effecting its inductions via sonic hedgehog (Shh), a signaling molecule which drives morphogenetic information for the thalamus. Using experimental embryological techniques involving the generation of chimeric embryos, we show that the formation of the ZLI in the diencephalic alar plate is due to an interaction between the prechordal and epichordal plate neuroepithelia. We also provide evidence that Shh expression in the ZLI underlies the morphogenetic activity of this putative diencephalic organizer. Ectopic Shh led to the auto-induction of its own gene expression in host cells, as well as to the expression of other genes involved in diencephalic regionalization and histogenesis. Analysis of long-term surviving embryos after Shh ectopic expression demonstrated that Shh was able to induce thalamic structures and local overgrowth. Overall, these results indicate that Shh expressed in the ZLI plays an important role in diencephalic growth and in the development of the thalamus.