The use of embryonic stem cells (ESCs) to regenerate distal lung epithelia damaged by injuries or diseases requires development of safe and efficient methodologies that direct ESC differentiation into transplantable distal lung epithelial progenitors. Time-consuming culture procedure and low differentiation efficiency are major problems that are associated with conventional differentiation approaches via embryoid body formation. The use of a growth factor cocktail or a lung-specific cell-conditioned medium to enrich definitive endoderm for efficient differentiation of mouse ESCs (mESC) into alveolar epithelial progenitor type II cells (ATIICs) has been reported, but not yet successful for generating a homogenous population of ATIICs for tissue regeneration purpose, and it remains unclear whether or not those mESC-derived ATIICs possess normal biological functions. Here, we report a novel method using a genetically modified mESC line harboring an ATIIC-specific neomycin(R) transgene in Rosa 26 locus. We showed that ATIICs can be efficiently differentiated from mESCs as early as day 7 by culturing them directly on Matrigel-coated plates in DMEM containing 15% knockout serum replacement. With this culture condition, the genetically modified mESCs can be selectively differentiated into a homogenous population (>99%) of ATIICs. Importantly, the mESC-derived ATIICs (mESC-ATIICs) exhibited typical lamellar bodies and expressed surfactant protein A, B, and C as normal control ATIICs. When cultured with an air-liquid-interface culture system in Small Airway Epithelial Cell Growth Medium, the mESC-ATIICs can be induced to secrete surfactant proteins after being treated with dibutyryl cAMP+dexamethasone. These mESC-ATIICs can synthesize and secrete surfactant lipid in response to secretagogue, demonstrating active surfactant metabolism in mESC-ATIICs as that seen in normal control ATIICs. In addition, we demonstrated that the selected mESC-ATIICs can be maintained on Matrigel-coated plates for at least 4 days with robust proliferative capacity. When cultured in DMEM medium containing 10% FBS, mESC-ATIICs spontaneously differentiated into alveolar epithelial type I cells. Collectively, these data demonstrate that the genetically modified mESCs can be selectively differentiated into a homogenous population of functional ATIICs, providing a reliable cell source to explore their therapeutic potential in lung tissue regeneration.