Pancreatic β-cell replacement by islet transplantation for the treatment of type 1 diabetes (T1D) is currently limited by donor tissue scarcity and the requirement for lifelong immunosuppression. The advent of in vitro differentiation protocols for generating functional β-like cells from human pluripotent stem cells, also referred to as SC-β cells, could eliminate these obstacles. To avoid the need for immunosuppression, alginate-microencapsulation is widely investigated as a safe path to β-cell replacement. Nonetheless, inflammatory foreign body responses leading to pericapsular fibrotic overgrowth often causes microencapsulated islet-cell death and graft failure. Here we used a novel approach to evade the pericapsular fibrotic response to alginate-microencapsulated SC-β cells; an immunomodulatory chemokine, CXCL12, was incorporated into clinical grade sodium alginate to microencapsulate SC-β cells. CXCL12 enhanced glucose-stimulated insulin secretion activity of SC-β cells and induced expression of genes associated with β-cell function in vitro. SC-β cells co-encapsulated with CXCL12 showed enhanced insulin secretion in diabetic mice and accelerated the normalization of hyperglycemia. Additionally, SC-β cells co-encapsulated with CXCL12 evaded the pericapsular fibrotic response, resulting in long-term functional competence and glycemic correction (>150 days) without systemic immunosuppression in immunocompetent C57BL/6 mice. These findings lay the groundwork for further preclinical translation of this approach into large animal models of T1D. © 2019 The American Society of Transplantation and the American Society of Transplant Surgeons.