Pulmonary hypoplasia is the principal cause of morbidity and mortality in infants with congenital diaphragmatic hernia (CDH). Still, relatively little is known about the mechanisms causing lung hypoplasia associated with CDH. The differentiation from alveolar epithelial cells type II (AECs-II) into alveolar epithelial cells type I (AECs-I) is one of the key processes in lung development in late gestation. It is well known that increased lung expansion promotes differentiation into AECs-I phenotype, whereas reduced lung expansion promotes AECs-II phenotype. The recent availability of cell-specific molecule markers for AECs-I and AECs-II has provided an opportunity to study the various characteristics of these two cell types. To test the hypothesis that the differentiation of AECs-II to AECs-I is impaired in the CDH hypoplastic lung, we investigated molecular markers for AECs-I [ICAM-1, T1alpha, aquaporin 5 (AQP5)] and molecular markers for AECs-II [thyroid transcription factor-1 (Ttf-1), surfactant protein (SP)-B and C] in the nitrofen-induced CDH lung. Fetal rat lungs of normal (n = 7) and nitrofen-treated (n = 14) dams were harvested on embryonic day 21. The expression of the ICAM1, T1alpha, AQP5, SP-B, C and Ttf-1 was analyzed in each lung by real-time reverse transcription polymerase chain reaction. Immunohistochemical studies were performed to evaluate the protein expression level of ICAM1 and Ttf1. Expression levels of ICAM-1, T1alpha and AQP5 were significantly reduced (P < 0.05) in the lungs from nitrofen-treated CDH animals compared to normal controls. ICAM-1 and AQP5 immunohistochemistry showed a diffuse pattern of expression in the alveolar cells in normal lungs. By contrast, the ICAM-1 and AQP5 positive cells were markedly reduced in hypoplastic lungs with CDH. On the other hand, the expression levels of Ttf-1, SP-B and C were significantly (P < 0.05) increased in the lungs from nitrofen-treated CDH animals compared to normal controls. The population of Ttf-1 positive cells was slightly increased in the lungs from nitrofen-treated animals in immunohistochemical study. Our results demonstrate that there is significant reduction in the proportion of AECs-I and increase in the proportion of AECs-II in the hypoplastic lung in the nitrofen-induced CDH. This data provides the first evidence to support the hypothesis that AEC differentiation is impaired in CDH hypoplastic lung.