Signaling by lipid-modified secreted glycoproteins of the Hedgehog family play fundamental roles during pattern formation in animal development and in humans; dysfunction of Hedgehog pathway components is frequently associated with a variety of congenital abnormalities and cancer. Transcriptional regulation of Hedgehog target genes is mediated by members of the Gli zinc-finger transcription factors. The relative nuclear concentrations of Gli activator (Gli(act)) and repressor (Gli(rep)) forms, together with their nucleocytoplasmic trafficking, appear to be critical determinants for target gene expression. Whereas such stringent controls of Gli activity are critical in ensuring appropriate levels of pathway activation, the mechanisms by which these processes are regulated remain inadequately understood. Here, using genetic analysis, we show that the zebrafish iguana gene product acts downstream of the Smoothened protein to modulate Gli activity in the somites of the developing embryo. Positional cloning reveals that iguana encodes the zebrafish ortholog of Dzip1, a novel zinc-finger/coiled-coil domain protein that we show can shuttle between the cytoplasm and nucleus in a manner correlated with Hedgehog pathway activity.