Transplantation of progenitor cells to the CNS has shown promise in neuronal and glial replacement and as a means of rescuing host neurons from apoptosis. Here we examined the effect of progenitor grafts on neurite extension in the degenerating retina of rd1 (retinal degeneration 1) mice. Transplantation of retinal progenitor cells induced increased matrix metalloproteinase-2 (MMP2) secretion, partly from activated glial cells, which was then activated by neuronally expressed MMP14. Active MMP2 resulted in proteolysis of the neurite outgrowth inhibitors CD44 and neurocan in the degenerative retina, allowing significantly increased neurite outgrowth across the border between abutting nondystrophic and rd1 retinas. Progenitor-induced enhancement of outgrowth was abrogated by an MMP inhibitor or by coculture with retinal explants from MMP2^−/− mice. This study provides the first identification of an MMP2-dependent mechanism by which exogenous progenitor cells alter the host environment to promote neural regeneration. This suggests a novel therapeutic role for progenitor cells in the treatment of CNS degenerative diseases.