We have examined the development and transgene expression in liver lesions of transgenic mice bearing the hepatitis B surface antigen (HBsAg) gene of hepatitis B virus under the control of the albumin promoter (alb/psx) to study liver regeneration and hepatocellular carcinoma (HCC) associated with hepatitis B virus infection. Storage of the HBsAg in the endoplasmic reticulum precedes loss of liver cells and regenerative hyperplastic nodules that do not express HBsAg. Histological analysis indicated that HBsAg-negative foci and nodules arose from liver progenitor cells in the portal zone and lacked mRNA expression. Genomic DNA from eight of nine HBsAg-negative laser capture-excised liver foci showed loss of part of the alb/psx gene, whereas no loss of the actin gene was observed. The alb/psx DNA was intact in adjacent HBsAg-positive tissue. Sequencing of polymerase chain reaction products suggested that alterations in the HBsAg transgene in HBsAg-negative foci occurred via large-scale deletions as opposed to single-site mutations. Southern blot analysis of HCC from 2-year-old transgenic HBsAg mice, however, revealed an intact alb/psx gene. Thus, HBsAg-negative progenitor cells with deletions in the transgene appear to be responsible for compensatory regeneration of the liver, whereas HCCs arise from clonal expansion of hepatocytes with intact alb/psx transgenes.