Pericapsular fibrotic overgrowth (PFO) is associated with poor survival of encapsulated islets. A strategy to combat PFO is the use of mesenchymal stem cells (MSC). MSC have anti-inflammatory properties and their potential can be enhanced by stimulation with proinflammatory cytokines. This study investigated whether co-encapsulation or co-transplantation of MSC with encapsulated islets would reduce PFO and improve graft survival. Stimulating MSC with a cytokine cocktail of IFN-γ and TNF-α enhanced their immunosuppressive potential by increasing nitric oxide production and secreting higher levels of immunomodulatory cytokines. In vitro, co-encapsulation with MSC did not affect islet viability but significantly enhanced glucose-induced insulin secretion. In vivo, normoglycemia was achieved in 100% mice receiving islets co-encapsulated with stimulated MSC as opposed to 71.4% receiving unstimulated MSC and only 9.1% receiving encapsulated islets alone. Microcapsules retrieved from both unstimulated and stimulated MSC groups had significantly less PFO with improved islet viability and function compared to encapsulated islets alone. Levels of peritoneal immunomodulatory cytokines IL-4, IL-6, IL-10 and G-CSF were significantly higher in MSC co-encapsulated groups. Similar results were obtained when encapsulated islets and MSC were co-transplanted. In summary, co-encapsulation or co-transplantation of MSC with encapsulated islets reduced PFO and improved the functional outcome of allotransplants.