The lymphoid-specific tyrosine phosphatase (Lyp) has generated enormous interest because a single-nucleotide polymorphism in the gene (PTPN22) encoding Lyp produces a gain-of-function mutant phosphatase that is associated with several autoimmune diseases, including type I diabetes, rheumatoid arthritis, Graves disease, and systemic lupus erythematosus. Thus, Lyp represents a potential target for a broad spectrum of autoimmune disorders. Unfortunately, no Lyp inhibitor has been reported. In addition, little is known about the structure and biochemical mechanism that directly regulates Lyp function. Here, we report the identification of a bidentate salicylic acid-based Lyp inhibitor I-C11 with excellent cellular efficacy. Structural and mutational analyses indicate that the inhibitor binds both the active site and a nearby peripheral site unique to Lyp, thereby furnishing a solid foundation upon which inhibitors with therapeutic potency and selectivity can be developed. Moreover, a comparison of the apo- and inhibitor-bound Lyp structures reveals that the Lyp-specific region S(35)TKYKADK(42), which harbors a PKC phosphorylation site, could adopt either a loop or helical conformation. We show that Lyp is phosphorylated exclusively at Ser-35 by PKC both in vitro and in vivo. We provide evidence that the status of Ser-35 phosphorylation may dictate the conformational state of the insert region and thus Lyp substrate recognition. We demonstrate that Ser-35 phosphorylation impairs Lyp's ability to inactivate the Src family kinases and down-regulate T cell receptor signaling. Our data establish a mechanism by which PKC could attenuate the cellular function of Lyp, thereby augmenting T cell activation.