Tregs control various functions of effector T cells; however, where and how Tregs exert their immunomodulatory effects remain poorly understood. Here we developed a murine model of adoptive T cell therapy and found that Tregs induce a dysfunctional state in tumor-infiltrating CTLs that resembles T cell exhaustion and is characterized by low expression of effector cytokines, inefficient cytotoxic granule release, and coexpression of coinhibitory receptors PD-1 and TIM-3. Induction of CTL dysfunction was an active process, requiring local TCR signals in tumor tissue. Tregs infiltrated tumors only subsequent to Ag-dependent activation and expansion in tumor-draining LNs; however, Tregs also required local Ag reencounter within tumor tissue to induce CTL dysfunction and prevent tumor rejection. Multiphoton intravital microscopy revealed that in contrast to CTLs, Tregs only rarely and briefly interrupted their migration in tumor tissue in an Ag-dependent manner and formed unstable tethering-interactions with CD11c⁺ APCs, coinciding with a marked reduction of CD80 and CD86 on APCs. Activation of CTLs by Treg-conditioned CD80/86^lo DCs promoted enhanced expression of both TIM-3 and PD-1. Based on these data, we propose that Tregs locally change the costimulatory landscape in tumor tissue through transient, Ag-dependent interactions with APCs, thus inducing CTL dysfunction by altering the balance of costimulatory and coinhibitory signals these cells receive.