The mammalian auditory sensory epithelium (the organ of Corti) contains a number of unique cell types that are arranged in ordered rows. Two of these cell types, inner and outer pillar cells (PCs), are arranged in adjacent rows that form a boundary between a single row of inner hair cells and three rows of outer hair cells (OHCs). PCs are required for auditory function, as mice lacking PCs owing to a mutation in Fgfr3 are deaf. Here, using in vitro and in vivo techniques, we demonstrate that an Fgf8 signal arising from the inner hair cells is the key component in an inductive pathway that regulates the number, position and rate of development of PCs. Deletion of Fgf8 or inhibition of binding between Fgf8 and Fgfr3 leads to defects in PC development, whereas overexpression of Fgf8 or exogenous Fgfr3 activation induces ectopic PC formation and inhibits OHC development. These results suggest that Fgf8-Fgfr3 interactions regulate cellular patterning within the organ of Corti through the induction of one cell fate (PC) and simultaneous inhibition of an alternate fate (OHC) in separate progenitor cells. Some of the effects of both inhibition and overactivation of the Fgf8-Fgfr3 signaling pathway are reversible, suggesting that PC differentiation is dependent upon constant activation of Fgfr3 by Fgf8. These results suggest that PCs might exist in a transient state of differentiation that makes them potential targets for regenerative therapies.