DNA methylation is a major epigenetic mechanism for gene silencing. Whereas methyltransferases mediate cytosine methylation, it is less clear how unmethylated regions in mammalian genomes are protected from de novo methylation and whether an active demethylating activity is involved. Here, we show that either knockout or catalytic inactivation of the DNA repair enzyme thymine DNA glycosylase (TDG) leads to embryonic lethality in mice. TDG is necessary for recruiting p300 to retinoic acid (RA)-regulated promoters, protection of CpG islands from hypermethylation, and active demethylation of tissue-specific developmentally and hormonally regulated promoters and enhancers. TDG interacts with the deaminase AID and the damage response protein GADD45a. These findings highlight a dual role for TDG in promoting proper epigenetic states during development and suggest a two-step mechanism for DNA demethylation in mammals, whereby 5-methylcytosine and 5-hydroxymethylcytosine are first deaminated by AID to thymine and 5-hydroxymethyluracil, respectively, followed by TDG-mediated thymine and 5-hydroxymethyluracil excision repair. Display omitted Display omitted ► Inactivation of TDG leads to embryonic lethality and altered DNA methylation patterns ► TDG keeps CpG islands unmethylated and actively demethylates promoters and enhancers ► TDG interacts with AID and GADD45a and regulates the levels of AID ► TDG removes 5-hydromethyluracil originated by deamination of 5-hydroxymethylcytosine