The short gastrulation (sog) gene is expressed in broad lateral stripes comprising the neuroectoderm of the Drosophila blastoderm embryo. sog encodes a predicted secreted protein that functions nonautonomously to antagonize the activity of the TGF-beta-like Decapentaplegic (Dpp) signaling pathway in the dorsal region of the embryo. Recently, it has been shown that sog and dpp are functionally equivalent to their respective Xenopus homologs chordin and BMP-4. In this report we provide the first direct evidence that sog plays a local role in the lateral region of the blastoderm embryo to oppose Dpp activity in the neuroectoderm. In the dorsal region, Dpp signaling both suppresses neurogenesis and maintains expression of genes that promote dorsal cell fates (dorsalization). We show that Dpp also can perform both of these functions in the neuroectoderm. In wild-type embryos, the ability of Dpp to induce expression of dorsal markers including itself (autoactivation) in the neuroectoderm is blocked by sog. We propose that Sog protects the neuroectoderm from an invasive positive feedback loop created by Dpp diffusion and autoactivation. We show that the two functions of Dpp signaling, neural suppression and dorsalization, are triggered by distinct thresholds of Dpp activity. Epistasis experiments reveal that all observed sog activity can be accounted for by Sog functioning as a dedicated Dpp antagonist. Finally, we provide evidence that Sog functions as a diffusible morphogen in the blastoderm embryo. These data strongly support the view that the primary phylogenetically conserved function of the Drosophila sog and dpp genes and the homologous Xenopus chordin and BMP-4 genes is to subdivide the primitive embryonic ectoderm into neural versus non-neural domains.