Successful muscle regeneration relies on the interplay of multiple cell populations. However, the signals required for this coordinated intercellular crosstalk remain largely unknown. Here, we describe how the Hedgehog (Hh) signaling pathway controls the fate of fibro/adipogenic progenitors (FAPs), the cellular origin of intramuscular fat (IMAT) and fibrotic scar tissue. Using conditional mutagenesis and pharmacological Hh modulators in vivo and in vitro, we identify DHH as the key ligand that acts as a potent adipogenic brake by preventing the adipogenic differentiation of FAPs. Hh signaling also impacts muscle regeneration, albeit indirectly through induction of myogenic factors in FAPs. Our results also indicate that ectopic and sustained Hh activation forces FAPs to adopt a fibrogenic fate resulting in widespread fibrosis. In this work, we reveal crucial post-developmental functions of Hh signaling in balancing tissue regeneration and fatty fibrosis. Moreover, they provide the exciting possibility that mis-regulation of the Hh pathway with age and disease could be a major driver of pathological IMAT formation.