Osteoblasts and chondrocytes are involved in building up the vertebrate skeleton and are thought to differentiate from a common mesenchymal precursor, the osteo-chondroprogenitor. Although numerous transcription factors involved in chondrocyte and osteoblast differentiation have been identified, little is known about the signals controlling lineage decisions of the two cell types. Here, we show by conditionally deleting β-catenin in limb and head mesenchyme that β-catenin is required for osteoblast lineage differentiation. Osteoblast precursors lacking β-catenin are blocked in differentiation and develop into chondrocytes instead. In vitro experiments demonstrate that this is a cell-autonomous function of β-catenin in an osteoblast precursor. Furthermore, detailed in vivo and in vitro loss- and gain-of-function analyses reveal that β-catenin activity is necessary and sufficient to repress the differentiation of mesenchymal cells into Runx2- and Sox9-positive skeletal precursors. Thus, canonical Wnt/β-catenin signaling is essential for skeletal lineage differentiation, preventing transdifferentiation of osteoblastic cells into chondrocytes.