Type II alveolar epithelial cells (AEC II) proliferate and transdifferentiate into type I alveolar epithelial cells (AEC I) when the normal AEC I population is damaged in the lung alveoli. We hypothesized that signaling by transforming growth factor beta1 (TGF beta1), through its downstream Smad proteins, is involved in keeping AEC II quiescent in normal cells and its altered signaling may be involved in the trans-differentiation of AEC II to AEC I. In the normal lung, TGF beta1 and Smad4 were highly expressed in AEC II. Using an in vitro cell culture model, we demonstrated that the trans-differentiation of AEC II into AEC I-like cells began with a proliferative phase, followed by a differentiation phase. The expression of TGF beta1, Smad2, and Samd3 and their phosphorylated protein forms, and cell cycle inhibitors, p15(Ink4b) and p21(Cip1), was lower during the proliferative phase but higher during the differentiation phase. Furthermore, cyclin-dependent kinases 2, 4, and 6 showed an opposite trend of expression. TGF beta1 secretion into the media increased during the differentiation phase, indicating an autocrine regulation. The addition of TGF beta1 neutralizing antibody after the proliferative phase and silencing of Smad4 by RNA interference inhibited the trans-differentiation process. In summary, our results suggest that the trans-differentiation of AEC II to AEC I is modulated by signaling through the Smad-dependent TGF beta1 pathway by altering the expression of proteins that control the G1 to S phase entry in the cell cycle.