Proper cell fate determination in mammalian gonads is critical for the establishment of sexual identity. The Hedgehog (Hh) pathway has been implicated in cell fate decision for various organs, including gonads. Desert Hedgehog (Dhh), one of the three mammalian Hh genes, has been implicated with other genes in the establishment of mouse fetal Leydig cells. To investigate whether Hh alone is sufficient to induce fetal Leydig cell differentiation, we ectopically activated the Hh pathway in Steroidogenic factor 1 (SF1)-positive somatic cell precursors of fetal ovaries. Hh activation transformed SF1-positive somatic ovarian cells into functional fetal Leydig cells. These ectopic fetal Leydig cells produced androgens and insulin-like growth factor 3 (INLS3) that cause virilization of female embryos and ovarian descent. However, the female reproductive system remained intact, indicating a typical example of female pseudohermaphroditism. The appearance of fetal Leydig cells was a direct consequence of Hh activation as evident by the absence of other testicular components in the affected ovary. This study provides not only insights into mechanisms of cell lineage specification in gonads, but also a model to understand defects in sexual differentiation.