Intraflagellar transport (IFT) proteins are essential for cilia assembly and have recently been associated with a number of developmental processes, such as left-right axis specification and limb and neural tube patterning. Genetic studies indicate that IFT proteins are required for Sonic hedgehog (Shh) signaling downstream of the Smoothened and Patched membrane proteins but upstream of the Glioma (Gli) transcription factors. However, the role that IFT proteins play in transduction of Shh signaling and the importance of cilia in this process remain unknown. Here we provide insights into the mechanism by which defects in an IFT protein, Tg737/Polaris, affect Shh signaling in the murine limb bud. Our data show that loss of Tg737 results in altered Gli3 processing that abrogates Gli3-mediated repression of Gli1 transcriptional activity. In contrast to the conclusions drawn from genetic analysis, the activity of Gli1 and truncated forms of Gli3 (Gli3R) are unaffected in Tg737 mutants at the molecular level, indicating that Tg737/Polaris is differentially involved in specific activities of the Gli proteins. Most important, a negative regulator of Shh signaling, Suppressor of fused, and the three full-length Gli transcription factors localize to the distal tip of cilia in addition to the nucleus. Thus, our data support a model where cilia have a direct role in Gli processing and Shh signal transduction.