Embryonic stem (ES) cells have been proposed to be a powerful tool in the study of pancreatic disease, as well as a potential source for cell replacement therapy in the treatment of diabetes. However, data demonstrating the feasibility of using pancreatic islet-like cells differentiated from ES cells remain controversial. In this study we characterized ES cell-derived insulin-expressing cells and assessed their suitability for the treatment of type I diabetes. ES cell-derived insulin-stained cell clusters expressed insulin mRNA and transcription factors associated with pancreatic development. The majority of insulin-positive cells in the clusters also showed immunoreactivity for C-peptide. Insulin was stored in the cytoplasm and released into the culture medium in a glucose-dependent manner. When the cultured cells were transplanted into diabetic mice, they reversed the hyperglycemic state for approximately 3 weeks, but the rescue failed due to immature teratoma formation. Our studies demonstrate that reversal of hyperglycemia by transplantation of ES cell-derived insulin-producing cells is possible. However, the risk of teratoma formation would need to be eliminated before ES cell-based therapies for the treatment of diabetes are considered.