Development of mammalian lung involves reiterative outgrowth and branching of an epithelial tube into the surrounding mesenchymal bed. Each coordinated growth and branching cycle is driven by reciprocal signalling between epithelial and adjacent mesenchymal cells. This signalling network includes FGF, SHH, BMP4 and other pathways. We have characterized lung defects in 36Pub mice carrying a deletion that removes an antagonist of FGF signalling, Spry2. Spry2 deficient mice show an enlarged cystic structure located in the terminus of each lobes. Our study shows that Spry2 deficient lungs have reduced lung branching and the cystic structure forms in the early lung development stage. Furthermore, mice carrying a targeted disruption of Spry2 fail to complement the lung phenotype characterized in 36Pub mice. A Spry2-BAC transgene rescues the defect. Interestingly, cystic structure growth is accompanied by the reduced and spatially disorganized expression of Fgf10 and elevated expression of Shh and Bmp4. Altered signalling balance due to the loss of Spry2 causes a delayed branch cycle and cystic growth. Our data underscores the importance of restricting cellular responsiveness to signalling and highlights the interplay between morphogenesis events and spatial localization of gene expression.