We have analyzed the effects of vaccinia virus (VV) on gamma interferon (IFN-gamma) signal transduction. Infection of cells with VV 1 to 2 h prior to treatment with IFN-gamma inhibits phosphorylation and nuclear translocation of Stat1 and consequently blocks accumulation of mRNAs normally induced by IFN-gamma. While phosphorylation of other proteins in the IFN-gamma pathway was not affected, activation of Stat1 by other ligand-receptor systems was also blocked by VV. This block of Stat1 activation was dose dependent, and although viral protein synthesis was not required, entry and uncoating of viral cores appear to be needed to block the accumulation of phosphorylated Stat1. These results suggest that a virion component is responsible for the effect. VV virions contain a phosphatase (VH1) that is sensitive to the phosphatase inhibitor Na(3)VO(4) but not to okadaic acid. Addition of Na(3)VO(4) but not okadaic acid restored normal Stat1 phosphorylation levels in VV-infected cells. Moreover, virions containing reduced levels of VH1 were unable to block the IFN-gamma signaling pathway. In vitro studies show that the phosphatase can bind and dephosphorylate Stat1, indicating that this transcription factor can be a substrate for VH1. Our results reveal a novel mechanism by which VV interferes with the onset of host immune responses by blocking the IFN-gamma signal cascade through the dephosphorylating activity of the viral phosphatase VH1.