To study the influence of subcellular localization as a determinant of signal transduction specificity, we assessed the effects of wild-type transmembrane and cytoplasmic protein tyrosine phosphatase (PTP) epsilon on tyrosine kinase signalling in baby hamster kidney (BHK) cells overexpressing the insulin receptor (BHK-IR). The efficiency by which differently localized PTPepsilon and PTPalpha variants attenuated insulin-induced cell rounding and detachment was determined in a functional clonal-selection assay and in stable cell lines. Compared with the corresponding receptor-type PTPs, the cytoplasmic PTPs (cytPTPs) were considerably less efficient in generating insulin-resistant clones, and exceptionally high compensatory expression levels were required to counteract phosphotyrosine-based signal transduction. Targeting of cytPTPepsilon to the plasma membrane via the Lck-tyrosine kinase dual acylation motif restored high rescue efficiency and abolished the need for high cytPTPepsilon levels. Consistent with these results, expression levels and subcellular localization of PTPepsilon were also found to determine the phosphorylation level of cellular proteins including focal adhesion kinase (FAK). Furthermore, PTPepsilon stabilized binding of phosphorylated FAK to Src, suggesting this complex as a possible mediator of the PTPepsilon inhibitory response to insulin-induced cell rounding and detachment in BHK-IR cells. Taken together, the present localization-function study indicates that transcriptional control of the subcellular localization of PTPepsilon may provide a molecular mechanism that determines PTPepsilon substrate selectivity and isoform-specific function.