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Mesenchymal stem cells (MSCs) are multi-potent progenitor cells that are isolated from the bone marrow and several adult organs and tissues. These cells possess remarkable immunosuppressive properties and can inhibit the proliferation and function of the major immune cell populations, including T cells, B cells and natural killer (NK) cells; modulate the activities of dendritic cells (DCs); and induce regulatory T cells both in vivo and in vitro. These unique properties make MSCs ideal candidates for clinical application as immunosuppressants. The immunomodulatory effect of MSCs is mediated by a non-specific anti-proliferative action of these cells, which is dependent on cell–cell contact or secreted soluble factors such as indoleamine 2,3-dioxygenase (IDO), prostaglandin E2 (PGE2), nitric oxide (NO), histocompatibility leucocyte antigen-G (HLA-G), transforming growth factor (TGF)-β, interferon (IFN)-γ and interleukin (IL)-1β. Considerable progress has been obtained in preclinical studies on MSCs, including those on their ability to activate allogeneic cells. This review examines the current understanding of the immunomodulatory properties of MSCs and its therapeutic implication for immune-mediated diseases and transplant rejection.