The differentiation of alveolar epithelial type I (AT1) and type II (AT2) cells is essential for the lung gas exchange function. Disruption of this process results in neonatal death or in severe lung diseases that last into adulthood. We developed live imaging techniques to characterize the mechanisms that control alveolar epithelial cell differentiation. We discovered that mechanical forces generated from the inhalation of amniotic fluid by fetal breathing movements are essential for AT1 cell differentiation. We found that a large subset of alveolar progenitor cells is able to protrude from the airway epithelium toward the mesenchyme in an FGF10/FGFR2 signaling-dependent manner. The cell protrusion process results in enrichment of myosin in the apical region of protruded cells; this myosin prevents these cells from being flattened by mechanical forces, thereby ensuring their AT2 cell fate. Our study demonstrates that mechanical forces and local growth factors synergistically control alveolar epithelial cell differentiation.