We assessed the ability of a gamma-secretase inhibitor to promote the in vitro differentiation of induced embryonic pancreatic precursor cell aggregates into functional islet-like clusters when encapsulated within a three-dimensional hydrogel. Undifferentiated pancreatic precursor cells were isolated from E.15 rat embryos, dissociated into single cells, and aggregated in suspension-rotation culture. Aggregates were photoencapsulated into poly(ethylene glycol) hydrogels with entrapped collagen type 1 and cultured for 14 days with or without a gamma-secretase inhibitor. Gene expression, proinsulin content, and C-peptide release were measured to determine differentiation and maturation of encapsulated precursor cell aggregates. In the control medium, scattered breakthrough beta cell differentiation was observed; however, cells remained largely insulin negative. Upon addition of a gamma-secretase inhibitor the majority of cells in clusters became insulin positive, and insulin per DNA and glucose-stimulated insulin release measurements for these cultures were comparable with those for adult rat islets. Cluster counts after culture day 14 were 88% of those initially encapsulated, demonstrating excellent cluster survival in hydrogel culture. These results indicate that concerted differentiation of pancreatic precursor cell aggregates into functionally mature islet-like clusters can be achieved in poly(ethylene glycol)-based hydrogel cultures by blocking cell contact-mediated Notch signaling with a gamma-secretase inhibitor.