Outgrowth and patterning of the vertebrate limb are controlled by reciprocal interactions between the posterior mesenchyme (polarizing region) and a specialized ectodermal structure, the apical ectodermal ridge (AER). Sonic hedgehog (SHH) signalling by the polarizing region modulates fibroblast growth factor (FGF)4 signalling by the posterior AER, which in turn maintains the polarizing region (SHH/FGF4 feedback loop). Here we report that the secreted bone-morphogenetic-protein (BMP) antagonist Gremlin relays the SHH signal from the polarizing region to the AER. Mesenchymal Gremlin expression is lost in limb buds of mouse embryos homozygous for the limb deformity (Id) mutation, which disrupts establishment of the SHH/FGF4 feedback loop. Grafting Gremlin-expressing cells into ld mutant limb buds rescues Fgf4 expression and restores the SHH/FGF4 feedback loop. Analysis of Shh-null mutant embryos reveals that SHH signalling is required for maintenance of Gremlin and Formin (the gene disrupted by the ld mutations). In contrast, Formin, Gremlin and Fgf4 activation are independent of SHH signalling. This study uncovers the cascade by which the SHH signal is relayed from the posterior mesenchyme to the AER and establishes that Formin-dependent activation of the BMP antagonist Gremlin is sufficient to induce Fgf4 and establish the SHH/FGF4 feedback loop.