Lung morphogenesis is a well orchestrated, tightly regulated process through several molecular pathways, including TGF-β/bone morphogenetic protein (BMP) signaling. Alteration of these signaling pathways leads to lung malformation. We investigated the role of Follistatin-like 1 (Fstl1), a secreted follistatin-module-containing glycoprotein, in lung development. Deletion of Fstl1 in mice led to postnatal lethality as a result of respiratory failure. Analysis of the mutant phenotype showed that Fstl1 is essential for tracheal cartilage formation and alveolar maturation. Deletion of the Fstl1 gene resulted in malformed tracheal rings manifested as discontinued rings and reduced ring number. Fstl1-deficient mice displayed septal hypercellularity and end-expiratory atelectasis, which were associated with impaired differentiation of distal alveolar epithelial cells and insufficient production of mature surfactant proteins. Mechanistically, Fstl1 interacted directly with BMP4, negatively regulated BMP4/Smad1/5/8 signaling, and inhibited BMP4-induced surfactant gene expression. Reducing BMP signaling activity by Noggin rescued pulmonary atelectasis of Fstl1-deficient mice. Therefore, we provide in vivo and in vitro evidence to demonstrate that Fstl1 modulates lung development and alveolar maturation, in part, through BMP4 signaling.