Organization of the vertebrate inner ear is mainly dependent on localized signals from surrounding tissues. Previous studies demonstrated that sonic hedgehog (Shh) secreted from the floor plate and notochord is required for specification of ventral (auditory) and dorsal (vestibular) inner ear structures, yet it was not clear how this signaling activity is propagated. To elucidate the molecular mechanisms by which Shh regulates inner ear development, we examined embryos with various combinations of mutant alleles for Shh, Gli2 and Gli3. Our study shows that Gli3 repressor (R) is required for patterning dorsal inner ear structures, whereas Gli activator (A) proteins are essential for ventral inner ear structures. A proper balance of Gli3R and Gli2/3A is required along the length of the dorsoventral axis of the inner ear to mediate graded levels of Shh signaling, emanating from ventral midline tissues. Formation of the ventral-most otic region, the distal cochlear duct, requires robust Gli2/3A function. By contrast, the formation of the proximal cochlear duct and saccule, which requires less Shh signaling, is achieved by antagonizing Gli3R. The dorsal vestibular region requires the least amount of Shh signaling in order to generate the correct dose of Gli3R required for the development of this otic region. Taken together, our data suggest that reciprocal gradients of GliA and GliR mediate the responses to Shh signaling along the dorsoventral axis of the inner ear.