During the development of the appendicular skeleton, the cartilaginous templates undergo hypertrophic differentiation and remodels into bone, except for the cartilage most adjacent to joint cavities where hypertrophic differentiation and endochondral bone formation are prevented, and chondrocytes instead form articular cartilage. The mechanisms that prevent hypertrophic differentiation and endochondral bone formation of the articular cartilage have not been elucidated. To explore the role of the synovial microenvironment in chondrocyte differentiation, osteochondral allografts consisting of articular cartilage, epiphyseal bone, and growth plate cartilage from distal femoral epiphyses of inbred Lewis rats expressing enhanced green fluorescent protein from a ubiquitous promoter were transplanted either in inverted or original (control) orientation to matching sites in wildtype littermates, thereby allowing for tracing of transplanted cells and their progenies. We found that no hypertrophic differentiation occurred in the growth plate cartilage ectopically placed at the joint surface. Instead, the transplanted growth plate cartilage, with time, remodeled into articular cartilage. This finding suggests that the microenvironment at the articular surface inhibits hypertrophic differentiation and supports articular cartilage formation. To explore this hypothesis, rat chondrocyte pellets were cultured with and without synoviocyte-conditioned media. Consistent with the hypothesis, hypertrophic differentiation was inhibited and expression of the articular surface marker lubricin (Prg4) was dramatically induced when chondrocyte pellets were exposed to synovium- or synoviocyte-conditioned media, but not to chondrocyte- or osteoblast-conditioned media. Taken together, we present evidence for a novel mechanism by which synoviocytes, through the secretion of a factor or factors, act directly on chondrocytes to inhibit hypertrophic differentiation and endochondral bone formation and promote articular cartilage formation. This mechanism may have important implications for articular cartilage development, maintenance, and regeneration.