Transposable elements (TEs) are scattered across mammalian genomes. Silencing of TEs prevents harmful effects caused by either global activation leading to genome instability or insertional mutations disturbing gene transcription. However, whether the activation of a TE can cause disease without directly affecting gene expression is largely unknown. Here we show that a TE insertion can adopt nearby regulatory activity, resulting in the production of cell-type-specific viral-like particles (VLPs) that affect embryo formation. Failure to silence an LTR retrotransposon inserted upstream of the Fgf8 gene results in their co-expression during mouse development. VLP assembly in the Fgf8-expressing cells of the developing limb triggers apoptotic cell death, resulting in a limb malformation resembling human ectrodactyly. The phenotype can be rescued by mutating the retrotransposon coding sequence, thus preventing its full endogenous retroviral cycle. Our findings illustrate that TE insertions can be incorporated into the local genomic regulatory landscape and that VLP production in post-implantation embryos can cause developmental defects.