Inhibitor-2 of type 1 protein phosphatase is a phosphoprotein conserved among all eukaryotes, and it appears in both the nucleus and cytoplasm of tissue culture cells. We discovered that endogenous inhibitor-2 is concentrated in the nucleus of cells cultured at low density, whereas cells growing at high density excluded inhibitor-2 from the nucleus. There was rapid redistribution of inhibitor-2 when cells were replated at low or high density. Localization of myc-tagged forms of inhibitor-2 showed that residues 119-197 were required for nuclear accumulation in low-density cells and residues 78-119 were required for cytoplasmic localization in high-density cells. Fusion of inhibitor-2 residues 78-119 to green fluorescent protein was sufficient to produce cytoplasmic retention. Inhibitor-2 fused to triple tandem green fluorescent protein (100 kDa) was imported into the nucleus of low-density cells but was not excluded from the nucleus when cells reached high density, implying that inhibitor-2 was actively imported into the nucleus but exited by passive diffusion instead of active export. We conclude that inhibitor-2 contains two separate domains that control its localization in the nucleus or cytoplasm. This change in inhibitor-2 localization may direct inhibitor-2 to different forms of protein phosphatase 1 or change the localization of protein phosphatase, as part of the cellular response to cell-cell contacts at high density.