We have previously reported that tumor formation of ras-transformed keratinocytes can be suppressed by dermal fibroblasts through production of a diffusible growth inhibitory factor of the transforming growth factor-beta (TGF-beta) family. Keratinocytes transformed by ras and E1a oncogenes or papilloma-derived keratinocytes transformed by a ras oncogene show concomitant resistance to dermal fibroblast tumor suppression and TGF-beta growth inhibition. We report here that dermal fibroblast tumor suppression is associated with a striking induction of squamous cell differentiation and that this effect is blocked in tumors resistant to dermal fibroblast inhibition. This experimental system strongly supports the notion that suppression of tumorigenicity and induction of a differentiated phenotype are closely associated events.