T1alpha, a differentiation gene of lung alveolar epithelial type I cells, is developmentally regulated and encodes an apical membrane protein of unknown function. Morphological differentiation of type I cells to form the air-blood barrier starts in the last few days of gestation and continues postnatally. Although T1alpha is expressed in the foregut endoderm before the lung buds, T1alpha mRNA and protein levels increase substantially in late fetuses when expression is restricted to alveolar type I cells. We generated T1alpha null mutant mice to study the role of T1alpha in lung development and differentiation and to gain insight into its potential function. Homozygous null mice die at birth of respiratory failure, and their lungs cannot be inflated to normal volumes. Distal lung morphology is altered. In the absence of T1alpha protein, type I cell differentiation is blocked, as indicated by smaller airspaces, many fewer attenuated type I cells, and reduced levels of aquaporin-5 mRNA and protein, a type I cell water channel. Abundant secreted surfactant in the narrowed airspaces, normal levels of surfactant protein mRNAs, and normal patterns and numbers of cells expressing surfactant protein-B suggest that differentiation of type II cells, also alveolar epithelial cells, is normal. Anomalous proliferation of the mesenchyme and epithelium at birth with unchanged numbers of apoptotic cells suggests that loss of T1alpha and/or abnormal morphogenesis of type I cells alter the proliferation rate of distal lung cells, probably by disruption of epithelial-mesenchymal signaling.