Pancreatic islet encapsulation within semi-permeable materials has been proposed for transplantation therapy of type I diabetes mellitus. Polymer hydrogel networks used for this purpose have been shown to provide protection from islet destruction by immunoreactive cells and antibodies. However, one of the fundamental deficiencies with current encapsulation methods is that the permselective barriers cannot protect islets from cytotoxic molecules of low molecular weight that are diffusible into the capsule material, which subsequently results in beta-cell destruction. Use of materials that can locally inhibit the interaction between the permeable small cytotoxic factors and islet cells may prolong the viability and function of encapsulated islet grafts. Here we report the design of anti-inflammatory hydrogels supporting islet cell survival in the presence of diffusible pro-inflammatory cytokines. We demonstrated that a poly(ethylene glycol)-containing hydrogel network, formed by native chemical ligation and presenting an inhibitory peptide for islet cell surface IL-1 receptor, was able to maintain the viability of encapsulated islet cells in the presence of a combination of cytokines including IL-1 beta, TNF-alpha, and INF-gamma. In stark contrast, cells encapsulated in unmodified hydrogels were mostly destroyed by cytokines which diffused into the capsules. At the same time, these peptide-modified hydrogels were able to efficiently protect encapsulated cells against beta-cell specific T-lymphocytes and maintain glucose-stimulated insulin release by islet cells. With further development, the approach of encapsulating cells and tissues within hydrogels presenting anti-inflammatory agents may represent a new strategy to improve cell and tissue graft function in transplantation and tissue engineering applications.