The chimeric protein PAX3-FOXO1, resulting from a translocation between chromosomes 2 and 13, is the most common genetic aberration in the alveolar subtype of the human skeletal muscle tumor, rhabdomyosarcoma. To understand how PAX3-FOXO1 contributes to tumor development, we isolated and characterized muscle cells from transgenic mice expressing PAX3-FOXO1 under control of the PAX3 promoter. We demonstrate that these myoblasts are unable to complete myogenic differentiation because of an inability to up-regulate p57Kip2 transcription. This defect is caused by reduced levels of the EGR1 transcriptional activator resulting from a direct, destabilizing interaction with PAX3-FOXO1. Neither PAX3 nor FOXO1 share the ability to regulate p57Kip2 transcription. Thus, the breakage and fusion of the genes encoding these transcription factors creates a unique chimeric protein that controls a key cell-cycle and -differentiation regulator.