To examine the mechanism by which moderate weight reduction improves basal and insulin-stimulated rates of glucose metabolism in patients with type 2 diabetes, we used ¹H magnetic resonance spectroscopy to assess intrahepatic lipid (IHL) and intramyocellular lipid (IMCL) content in conjunction with hyperinsulinemic-euglycemic clamps using [6,6-²H₂]glucose to assess rates of glucose production and insulin-stimulated peripheral glucose uptake. Eight obese patients with type 2 diabetes were studied before and after weight stabilization on a moderately hypocaloric very-low-fat diet (3%). The diabetic patients were markedly insulin resistant in both liver and muscle compared with the lean control subjects. These changes were associated with marked increases in IHL (12.2 ± 3.4 vs. 0.6 ± 0.1%; P = 0.02) and IMCL (2.0 ± 0.3 vs. 1.2 ± 0.1%; P = 0.02) compared with the control subjects. A weight loss of only ∼8 kg resulted in normalization of fasting plasma glucose concentrations (8.8 ± 0.5 vs. 6.4 ± 0.3 mmol/l; P < 0.0005), rates of basal glucose production (193 ± 7 vs. 153 ± 10 mg/min; P < 0.0005), and the percentage suppression of hepatic glucose production during the clamp (29 ± 22 vs. 99 ± 3%; P = 0.003). These improvements in basal and insulin-stimulated hepatic glucose metabolism were associated with an 81 ± 4% reduction in IHL (P = 0.0009) but no significant change in insulin-stimulated peripheral glucose uptake or IMCL (2.0 ± 0.3 vs. 1.9 ± 0.3%; P = 0.21). In conclusion, these data support the hypothesis that moderate weight loss normalizes fasting hyperglycemia in patients with poorly controlled type 2 diabetes by mobilizing a relatively small pool of IHL, which reverses hepatic insulin resistance and normalizes rates of basal glucose production, independent of any changes in insulin-stimulated peripheral glucose metabolism.