Hedgehog controls the expression of key developmental genes through the conversion of the transcription factor Cubitus interruptus (Ci) into either an activator (Ci[act]) or a repressor (Ci[rep]) form. Proteolytic cleavage of full-length Ci is important for the generation of Ci[rep], but little is known about how Ci[act] arises in response to Hh. Here we examine Hh signal transduction components for their role in the conversion of full-length Ci into either Ci[act] or Ci[rep]. We report that Cos2, PKA and Fused are necessary for the generation of Ci[rep], whereas the inhibition of either Cos2 or PKA activity is a prerequisite for Ci[act] formation. Fused (Fu) kinase stimulates a constitutively active form of Ci in a Hh-dependent manner, suggesting that Fu enhances the activity rather than the formation of Ci[act]. Su(fu) reduces the nuclear accumulation of the constitutively active form of Ci, arguing that Su(fu) can function subsequent to Ci[act] formation. We propose that Hh induces target gene expression by a two-step mechanism in which Ci[act] is first formed and then accumulates in the nucleus via Fu-induced neutralization of Su(fu) activity.