Hematopoiesis and vasculogenesis in the mammalian embryo begin in the blood islands of the yolk sac and continue, somewhat later, within the embryo proper. A subset of the first endothelial and hematopoietic cells of the yolk sac arise in close spatial and temporal association, apparently from a common mesodermal progenitor, the "hemangioblast." The mechanisms that control formation of hemangioblast and embryonic hematopoietic and endothelial (angioblastic) stem/progenitor cells are still not well understood. Formation of these cell types from nascent mesoderm requires signals from an adjacent outer layer of primitive (visceral) endoderm. Indian hedgehog (Ihh), a member of the hedgehog family of extracellular morphogens, is secreted by visceral endoderm and alone is sufficient to induce hematopoiesis and vasculogenesis in explanted embryos. While gene targeting studies in mice support a role for hedgehog signaling in these processes in vivo, they also suggest that additional molecules (perhaps, for example, Wnt proteins) are required for induction and patterning of hematopoietic and vascular mesoderm. Indian hedgehog likely functions through upregulation of genes encoding other signaling molecules, such as bone morphogenetic protein (Bmp)-4, in the target tissue. This review will focus on hematopoietic and vascular development in the early mouse embryo and will discuss potential implications of recent studies for stem cell transplantation in humans.