Many patients with chronic hepatitis caused by hepatitis C virus (HCV) infection develop liver fibrosis with high risk for hepatocellular carcinoma (HCC), but the mechanism underling this process is unclear. Conversely, transforming growth factor beta (TGF‐β) activates not only TGF‐β type I receptor (TβRI) but also c‐Jun N‐terminal kinase (JNK), which convert the mediator Smad3 into two distinctive phosphoisoforms: C‐terminally phosphorylated Smad3 (pSmad3C) and linker‐phosphorylated Smad3 (pSmad3L). Whereas the TβRI/pSmad3C pathway suppresses epithelial cell growth by upregulating p21^WAF1 transcription, JNK/pSmad3L‐mediated signaling promotes extracellular matrix deposition, partly, by upregulating plasminogen activator inhibitor 1 (PAI‐1). We studied the domain‐specific Smad3 phosphorylation in biopsy specimens representing chronic hepatitis, cirrhosis, or HCC from 100 patients chronically infected with HCV, and correlated Smad3 phosphorylation with clinical course. As HCV‐infected livers progressed from chronic hepatitis through cirrhosis to HCC, hepatocytic pSmad3L/PAI‐1 increased with fibrotic stage and necroinflammatory grade, and pSmad3C/p21^WAF1 decreased. Of 14 patients with chronic hepatitis C with strong hepatocytic pSmad3L positivity, 8 developed HCC within 12 years; only 1 of 12 showing little pSmad3L positivity developed HCC. We further sought molecular mechanisms in vitro. JNK activation by the pro‐inflammatory cytokine interleukin‐1β stimulated the pSmad3L/PAI‐1 pathway in facilitating hepatocytic invasion, in the meantime reducing TGF‐β‐dependent tumor‐suppressive activity by the pSmad3C/p21^WAF1 pathway. Conclusion: These results indicate that chronic inflammation associated with HCV infection shifts hepatocytic TGF‐β signaling from tumor‐suppression to fibrogenesis, accelerating liver fibrosis and increasing risk for HCC. (HEPATOLOGY 2007;46:48–57.)