In bladder, loss of mammalian Sonic Hedgehog (Shh) accompanies progression to invasive urothelial carcinoma, but the molecular mechanisms underlying this cancer-initiating event are poorly defined. Here, we show that loss of Shh results from hypermethylation of the CpG shore of the Shh gene, and that inhibition of DNA methylation increases Shh expression to halt the initiation of murine urothelial carcinoma at the early stage of progression. In full-fledged tumors, pharmacologic augmentation of Hedgehog (Hh) pathway activity impedes tumor growth, and this cancer-restraining effect of Hh signaling is mediated by the stromal response to Shh signals, which stimulates subtype conversion of basal to luminal-like urothelial carcinoma. Our findings thus provide a basis to develop subtype-specific strategies for the management of human bladder cancer.