Hypomorphic mutations in the human SPINT2 gene cause a broad spectrum of abnormalities in organogenesis, including organ and digit duplications, atresia, fistulas, hypertelorism, cleft palate and hamartoma. SPINT2 encodes the transmembrane serine protease inhibitor HAI2(placental bikunin), and the severe developmental effects of decreased HAI2 activity can be hypothesized to be a consequence of excess pericellular proteolytic activity. Indeed, we show here that HAI2 is a potent regulator of protease-guided cellular responses, including motogenic activity and transepithelial resistance of epithelial monolayers. Furthermore, we show that inhibition of the transmembrane serine protease matriptase (encoded by St14) is an essential function of HAI2 during tissue morphogenesis. Genetic inactivation of the mouse Spint2 gene led to defects in neural tube closure, abnormal placental labyrinth development associated with loss of epithelial cell polarity, and embryonic demise. Developmental defects observed in HAI2-deficient mice were caused by unregulated matriptase activity, as both placental development and embryonic survival in HAI2-deficient embryos were completely restored by the simultaneous genetic inactivation of matriptase. However, neural tube defects were detected in HAI2-deficient mice even in the absence of matriptase, although at lower frequency, indicating that the inhibition of additional serine protease(s) by HAI2 is required to complete neural development. Finally, by genetic complementation analysis, we uncovered a unique and complex functional interaction between HAI2 and the related HAI1 in the regulation of matriptase activity during development. This study indicates that unregulated matriptase-dependent cell surface proteolysis can cause a diverse array of abnormalities in mammalian development.