Antigen-specific activation of T cells is an essential process in the control of effector immune responses. Defects in T cell activation, particularly in the co-stimulation step, have been associated with many autoimmune conditions including type 1 diabetes (T1D). Recently, we demonstrated that the phenotype of impaired negative co-stimulation, due to reduced levels of V-set domain-containing T cell activation inhibitor-1 (VTCN1) protein on antigen-presenting cells, is shared between diabetes-susceptible NOD mice and human T1D patients. Here, we show that a similar process takes place in the target organ, as both α and β cells within pancreatic islets gradually lose their VTCN1 protein during autoimmune diabetes development despite the up-regulation of the VTCN1 gene. Diminishment of functional islet cells' VTCN1 is caused by the active proteolysis by metalloproteinase NRD1 and leads to the significant induction of proliferation and cytokine production by diabetogenic T cells. Inhibition of NRD1 activity, on the other hand, stabilizes VTCN1 and dulls the anti-islet T cell responses. Therefore, we suggest a general endogenous mechanism of defective VTCN1 negative co-stimulation, which affects both lymphoid and peripheral target tissues during T1D progression and results in aggressive anti-islet T cell responses. This mechanism is tied to up-regulation of NRD1 expression and likely acts in two synergistic proteolytic modes: cell-intrinsic intracellular and cell-extrinsic systemic. Our results highlight an importance of VTCN1 stabilization on cell surfaces for the restoration of altered balance of immune control during T1D.