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Poly(ethylene glycol) (PEG)-based hydrogels are promising in situ cell carriers for tissue engineering. However, their success in vivo will in part depend upon the foreign body reaction (FBR). This study tests the hypothesis that the FBR affects cells encapsulated within PEG hydrogels, and in turn influences the severity of the FBR. Fibroblasts were encapsulated within PEG hydrogels containing RGD to support cell attachment. Macrophages were seeded on top of cell-laden hydrogels to mimic in vivo macrophage interrogation and treated with lipopolysaccharide to induce an inflammatory phenotype. The presence of activated macrophages reduced fibroblast gene expression for extracellular matrix molecules and remodeling, but stimulated VEGF and IL-1β gene expression. Fibroblasts impacted macrophage phenotype leading to increased iNOS, IL-1β and TNF-α expressions. Syngeneic cell-laden and acellular hydrogels were also implanted subcutaneously into C57bl/6 mice for 2, 7 and 28 days. Encapsulated fibroblasts secreted collagen type I during the first week, but tissue deposition and cellularity decreased by 28 days. The presence of encapsulated fibroblasts led to greater acute inflammation, but did not influence the fibrotic response. In summary, this work emphasizes the importance of the host response in tissue engineering, and the potentially deleterious impact it may have on cell-laden synthetic scaffolds.