The PAX3–FOXO1 fusion gene is generated by a 2;13 chromosomal translocation and is a characteristic feature of an aggressive subset of rhabdomyosarcoma (RMS). To dissect the mechanism of oncogene action during RMS tumourigenesis and progression, doxycycline‐inducible PAX3–FOXO1 and constitutive MYCN expression constructs were introduced into immortalized human myoblasts. Although myoblasts expressing PAX3–FOXO1 or MYCN alone were not transformed in focus formation assays, combined PAX3–FOXO1 and MYCN expression resulted in transformation. Following intramuscular injection into immunodeficient mice, myoblasts expressing PAX3–FOXO1 and MYCN formed rapidly growing RMS tumours, whereas myoblasts expressing only PAX3–FOXO1 formed tumours after a longer latency period. Doxycycline withdrawal in myoblasts expressing inducible PAX3–FOXO1 and constitutive MYCN following tumour formation in vivo or focus formation in vitro resulted in tumour regression or smaller foci associated with myogenic differentiation and cell death. Following regression, most tumours recurred in the absence of doxycycline. Analysis of recurrent tumours revealed a subset without PAX3–FOXO1 expression, and cell lines derived from these recurrent tumours showed transformation in the absence of doxycycline. The doxycycline‐independent oncogenicity in these recurrent tumour‐derived lines persisted even after PAX3–FOXO1 was inactivated with a CRISPR/Cas9 editing strategy. Whereas cell lines derived from primary tumours were dependent on PAX3–FOXO1 and differentiated following doxycycline withdrawal, recurrent tumour‐derived cells without PAX3–FOXO1 expression did not differentiate under these conditions. These findings indicate that PAX3–FOXO1 collaborates with MYCN during early RMS tumourigenesis to dysregulate proliferation and inhibit myogenic differentiation and cell death. Although most cells in the primary tumours are dependent on PAX3–FOXO1, recurrent tumours can develop by a PAX3–FOXO1‐independent mechanism, in which rare cells are postulated to acquire secondary transforming events that were activated or selected by initial PAX3–FOXO1 expression. Published 2016. This article is a U.S. Government work and is in the public domain in the USA.