The compensatory proliferation of insulin-producing β cells is critical to maintaining glucose homeostasis at the early stage of type 2 diabetes. Failure of β cells to proliferate results in hyperglycemia and insulin dependence in patients. To understand the effect of the interplay between β cell compensation and lipid metabolism upon obesity and peripheral insulin resistance, we eliminated LDL receptor-related protein 1 (LRP1), a pleiotropic mediator of cholesterol, insulin, energy metabolism, and other cellular processes, in β cells. Upon high-fat diet exposure, LRP1 ablation significantly impaired insulin secretion and proliferation of β cells. The diminished insulin signaling was partly contributed to by the hypersensitivity to glucose-induced, Ca2+-dependent activation of Erk and the mTORC1 effector p85 S6K1. Surprisingly, in LRP1-deficient islets, lipotoxic sphingolipids were mitigated by improved lipid metabolism, mediated at least in part by the master transcriptional regulator PPARγ2. Acute overexpression of PPARγ2 in β cells impaired insulin signaling and insulin secretion. Elimination of Apbb2, a functional regulator of LRP1 cytoplasmic domain, also impaired β cell function in a similar fashion. In summary, our results uncover the double-edged effects of intracellular lipid metabolism on β cell function and viability in obesity and type 2 diabetes and highlight LRP1 as an essential regulator of these processes.