In caudal regions of the diencephalon, sonic hedgehog (Shh) is expressed in the ventral midline of prosomeres 1-3 (p1-p3), which underlie the pretectum, thalamus and prethalamus, respectively. Shh is also expressed in the zona limitans intrathalamica (zli), a dorsally projecting spike that forms at the p2-p3 boundary. The presence of two Shh signaling centers in the thalamus has made it difficult to determine the specific roles of either one in regional patterning and neuronal fate specification. To investigate the requirement of Shh from a focal source of expression in the ventral midline of the diencephalon, we used a newly generated mouse line carrying a targeted deletion of the 525 bp intronic sequence mediating Shh brain enhancer-1 (SBE1) activity. In SBE1 mutant mice, Shh transcription was initiated but not maintained in the ventral midline of the rostral midbrain and caudal diencephalon, yet expression in the zli was unaffected. In the absence of ventral midline Shh, rostral thalamic progenitors (pTH-R) adopted the molecular profile of a more caudal thalamic subtype (pTH-C). Surprisingly, despite their early mis-specification, neurons derived from the pTH-R domain continued to migrate to their proper thalamic nucleus, extended axons along their normal trajectory and expressed some, but not all, of their terminal differentiation markers. Our results, and those of others, suggest a model whereby Shh signaling from distinct spatial and temporal domains in the diencephalon exhibits unique and overlapping functions in the development of discrete classes of thalamic interneurons.