The Drosophila strawberry (sty) locus was isolated by P-element insertion mutagenesis in a screen for mutations affecting eye development. Analysis of the mutant phenotype and the putative expression pattern of the sty gene suggested that it has multiple functions. Mutations in the sty gene lead to irregular spacing of ommatidia, an increase in the number of photoreceptor cells, as well as abnormal axonal projections to the lamina and disrupted structure of the optic lobes in the adult fly. The sty mutation also causes abnormal head involution, a change in a number of sensilla in the antennomaxillary complex in the embryonic stage and abnormal morphogenesis of the maxillary palp and wings in later stages. We examined the presumptive expression of the sty gene during development by histochemical staining for lacZ expression from enhancer trap elements inserted within the sty gene. During embryogenesis, expression of lacZ showed a segmental pattern in the ectoderm and in the nervous system. In the eye imaginal discs, lacZ was expressed in photoreceptor cells beginning a few rows posterior to the morphogenetic furrow. The lacZ was also expressed in the wing disc. In the adult, lacZ was expressed in the retina and lamina. We cloned the sty gene by P-element tagging and found that it encodes a putative secreted protein containing a cysteine-rich region similar to the epidermal growth factor (EGF) repeat. On the basis of the loss of functional phenotype, the expression pattern and the predicted structure of its product, we propose that sty encodes a diffusible protein acting as a signal involved in lateral inhibition within the developing nervous system and also as a factor involved either directly or indirectly in axonal guidance and optic lobe development.