Fibroblast growth factor receptor 3 (FGFR3) is a key regulator of skeletal growth and activating mutations in Fgfr3 cause achondroplasia, the most common genetic form of dwarfism in humans. Little is known about the mechanism by which FGFR3 inhibits bone growth and how FGFR3 signaling interacts with other signaling pathways that regulate endochondral ossification. To understand these mechanisms, we targeted the expression of an activated FGFR3 to growth plate cartilage in mice using regulatory elements from the collagen II gene. As with humans carrying the achondroplasia mutation, the resulting transgenic mice are dwarfed, with axial, appendicular and craniofacial skeletal hypoplasia. We found that FGFR3 inhibited endochondral bone growth by markedly inhibiting chondrocyte proliferation and by slowing chondrocyte differentiation. Significantly, FGFR3 downregulated the Indian hedgehog (Ihh) signaling pathway and Bmp4 expression in both growth plate chondrocytes and in the perichondrium. Conversely, Bmp4 expression is upregulated in the perichondrium of Fgfr3-/- mice. These data support a model in which Fgfr3 is an upstream negative regulator of the hedgehog (Hh) signaling pathway. Additionally, Fgfr3 may coordinate the growth and differentiation of chondrocytes with the growth and differentiation of osteoprogenitor cells by simultaneously modulating Bmp4 and patched expression in both growth plate cartilage and in the perichondrium.