Although activation of hedgehog (Hh) signaling has been shown to induce osteogenic differentiation in vitro and bone formation in vivo, the underlying mechanisms and the potential use of Hh-activated mesenchymal progenitors in bone defect repair remain elusive. In this study, we demonstrated that implantation of periosteal-derived mesenchymal progenitor cells (PDMPCs) that overexpressed an N-terminal sonic hedgehog peptide (ShhN) via an adenoviral vector (Ad-ShhN) restored periosteal bone collar formation in a 4-mm segmental bone allograft model in immunodeficient mice. Ad-ShhN enhanced donor cell survival and microvessel formation in collagen scaffold at 2 weeks after surgery and induced donor cell-dependent bone formation at 6 weeks after surgery. Fluorescence-activated cell sorting analysis further showed that Ad-ShhN-PDMPC-seeded scaffold contained a twofold more CD45(-)Sca-1(+)CD34(+)VEGFR2(+) endothelial progenitors than Ad-LacZ-PDMPC-seeded scaffold at day 7 after surgery. Ad-ShhN-transduced PDMPCs induced a 1.8-fold more CD31(+) microvessel formation than Ad-LacZ-transduced PDMPCs in a coculture of endothelial progenitors and PDMPCs. Taken together, our data show that overexpression of ShhN in mesenchymal progenitors improves bone defect reconstruction by enhancing donor progenitor cell survival, differentiation, and scaffold revascularization at the site of compromised periosteum. Hh agonist-based therapy, therefore, merits further investigation in tissue engineering-based applications aimed at enhancing bone defect repair and reconstruction.