Members of the Hedgehog (Hh) family of intercellular signaling molecules play crucial roles in animal development. Aberrant regulation of Hh signaling in humans causes developmental defects, and leads to various genetic disorders and cancers. We have characterized a novel regulator of Hh signaling through the analysis of the zebrafish midline mutant iguana (igu). Mutations in igu lead to reduced expression of Hh target genes in the ventral neural tube, similar to the phenotype seen in zebrafish mutants known to affect Hh signaling. Contradictory at first sight, igu mutations lead to expanded Hh target gene expression in somites. Genetic and pharmacological analyses revealed that the expression of Hh target genes in igu mutants requires Gli activator function but does not depend on Smoothened function. Our results show that the ability of Gli proteins to activate Hh target gene expression in response to Hh signals is generally reduced in igu mutants both in the neural tube and in somites. Although this reduced Hh signaling activity leads to a loss of Hh target gene expression in the neural tube, the same low levels of Hh signaling appear to be sufficient to activate Hh target genes throughout somites because of different threshold responses to Hh signals. We also show that Hh target gene expression in igu mutants is resistant to increased protein kinase A activity that normally represses Hh signaling. Together, our data indicate that igu mutations impair both the full activation of Gli proteins in response to Hh signals, and the negative regulation of Hh signaling in tissues more distant from the source of Hh. Positional cloning revealed that the igu locus encodes Dzip1, a novel intracellular protein that contains a single zinc-finger protein-protein interaction domain. Overexpression of Igu/Dzip1 proteins suggested that Igu/Dzip1 functions in a permissive way in the Hh signaling pathway. Taken together, our studies show that Igu/Dzip1 functions as a permissive factor that is required for the proper regulation of Hh target genes in response to Hh signals.