The Hedgehog (Hh) family of secreted proteins controls many aspects of growth and patterning in animal development. In Drosophila, Hh acts by preventing the formation of a truncated repressor form of Cubitus interruptus (Ci) and stimulating the transcriptional activity of full-length Ci. Here, we provide evidence that Costal2 (Cos2) and Suppressor of Fused [Su(fu)] inhibit Ci by tethering it in the cytoplasm, whereas Hh induces nuclear translocaltion of Ci through Fused (Fu). We have identified a 125 amino acid domain in the C-terminal part of Ci that mediates response to Cos2 inhibition. We show that Cos2 binds Ci, prevents its nuclear import, and inhibits its activity via this domain. We also provide evidence that Su(fu) regulates Ci through two distinct mechanisms: (1) Su(fu) blocks Ci nuclear import through the N-terminal region of Ci, and (2) it inhibits the activity of Ci through a mechanism independent of Ci nuclear translocation. Finally, we show that Cos2 is required for transducing high levels of Hh signaling activity, and it does so by alleviating the blockage of Ci activity imposed by Su(fu).