Cleft palate represents one of the most common congenital birth defects in human. During embryonic development, palatal shelves display oronasal (O-N) and anteroposterior polarity before the onset of fusion, but how the O-N pattern is established and how it relates to the expansion and fusion of the palatal shelves are unknown. Here we address these questions and show that O-N patterning is associated with the expansion and fusion of the palatal shelves and that Dlx5 is required for the O-N patterning of palatal mesenchyme. Loss of Dlx5 results in downregulation of Fgf7 and expanded Shh expression from the oral to the nasal side of the palatal shelf. This expanded Shh signaling is sufficient to restore palatal expansion and fusion in mice with compromised palatal mesenchymal cell proliferation, such as Msx1-null mutants. Exogenous Fgf7 inhibits Shh signaling and reverses the cranial neural crest (CNC) cell proliferation rescue in the Msx1/Dlx5 double knockout palatal mesenchyme. Thus, Dlx5-regulated Fgf7 signaling inhibits the expression of Shh, which in turn controls the fate of CNC cells through tissue-tissue interaction and plays a crucial role during palatogenesis. Our study shows that modulation of Shh signaling may be useful as a potential therapeutic approach for rescuing cleft palate.