Large bone defects naturally regenerate via a highly vascularized tissue which progressively remodels into cartilage and bone. Current approaches in bone tissue engineering are restricted by delayed vascularization and fail to recapitulate this stepwise differentiation toward bone tissue. Here, we use the morphogen Sonic Hedgehog (Shh) to induce the in vitro organization of an endothelial capillary network in an artificial tissue. We show that endogenous Hedgehog activity regulates angiogenic genes and the formation of vascular lumens. Exogenous Shh further induces the in vitro development of the vasculature (vascular lumen formation, size, distribution). Upon implantation, the in vitro development of the vasculature improves the in vivo perfusion of the artificial tissue and is necessary to contribute to, and enhance, the formation of de novo mature bone tissue. Similar to the regenerating callus, the artificial tissue undergoes intramembranous and endochondral ossification and forms a trabecular-like bone organ including bone-marrow-like cavities. These findings open the door for new strategies to treat large bone defects by closely mimicking natural endochondral bone repair.