Spinal cord contusion injury leads to severe loss of gray and white matter and subsequent deficit of motor and sensory functions below the lesion. In this study, we investigated whether application of murine clonal embryonic neuroectodermal stem cells can prevent the spinal cord secondary damage and induce functional recovery. Stem cells (NE-GFP-4C cell line) were grafted intraspinally or intravenously immediately or one week after thoracic spinal cord contusion injury. Control animals received cell culture medium or fibrin intraspinally one week after injury. Functional tests (Basso, Beattie, Bresnahan, CatWalk®) and detailed morphological analysis were performed to evaluate the effects of grafted cells. Stem cells applied either locally or intravenously induced significantly improved functional recovery compared with their controls. Morphologically, stem cell grafting prevented the formation of secondary injury and promoted sparing of the gray and white matters. The transplanted cells integrated into the host tissue and differentiated into neurons, astrocytes, and oligodendrocytes. In intraspinally grafted animals, the corticospinal tract axons regenerated along the ventral border of the cavity and have grown several millimeters, even beyond the caudal end of the lesion. The extent of regeneration and functional improvement was inversely related to the amounts of chondroitin sulphate and ephrin-B2 molecules around the cavity and to the microglial and astrocytic reactions in the injured segment early after injury. The grafts produced glial cell derived neurotrophic factor, macrophage inflammatory protein-1a, interleukin (IL)-6 and IL-10 in a paracrine fashion for at least one week. Treating the grafted cords with neutralizing antibodies against these four factors through the use of osmotic pumps nearly completely abolished the effect of the graft. The non-significant functional improvement after function blocking is likely because the stem cell derivatives settled in the injured cord. These data suggest that grafted neuroectodermal stem cells are able to prevent the secondary spinal cord damage and induce significant regeneration via multiple mechanisms.