Inhibitor-1 (I-1) and inhibitor-2 (I-2) selectively inhibit type 1 protein serine/threonine phosphatases (PP1). To define the molecular basis for PP1 inhibition by I-1 and I-2 charged-to-alanine substitutions in the Saccharomyces cerevisiae, PP1 catalytic subunit (GLC7), were analyzed. Two PP1 mutants, E53A/E55A and K165A/E166A/K167A, showed reduced sensitivity to I-2 when compared with wild-type PP1. Both mutants were effectively inhibited by I-1. Two-hybrid analysis and coprecipitation or pull-down assays established that wild-type and mutant PP1 catalytic subunits bound I-2 in an identical manner and suggested a role for the mutated amino acids in enzyme inhibition. Inhibition of wild-type and mutant PP1 enzymes by full-length I-2(1-204), I-2(1-114), and I-2(36-204) indicated that the mutant enzymes were impaired in their interaction with the N-terminal 35 amino acids of I-2. Site-directed mutagenesis of amino acids near the N terminus of I-2 and competition for PP1 binding by a synthetic peptide encompassing an I-2 N-terminal sequence suggested that a PP1 domain composed of amino acids Glu-53, Glu-55, Asp-165, Glu-166, and Lys-167 interacts with the N terminus of I-2. This defined a novel regulatory interaction between I-2 and PP1 that determines I-2 potency and perhaps selectivity as a PP1 inhibitor.