The spread of antibiotic resistance genes within and between bacterial species represents one of the most serious threats faced by clinical microbiologists today. In Gram-negative bacteria, the insertion sequence IS26 plays a major role in disseminating antibiotic resistance via the formation of compound transposons carrying resistance genes. In this study, we have examined how IS26 creates these compound transposons. The IS26 transposase, Tnp26, can perform an intra-molecular deletion reaction that removes a piece of adjacent DNA. A secondary product of this reaction is the formation of a circular molecule consisting of the deleted DNA segment and a single IS26, which we call a translocatable unit or TU. Circular TUs containing the aphA1a kanamycin and neomycin resistance gene or the tet(D) tetracycline resistance determinant were generated in vitro and transformed into recA Escherichia coli carrying R388:IS26. The TU incorporated next to the IS26 in R388::IS26 forming a transposon with the IS in direct orientation i.e. the incoming IS26 targeted the pre-existing one in R388::IS26. Introduction of a second TU produced regions containing both the aphA1a gene and the tet(D) determinant in either order but with only three copies of IS26. The integration reaction required a pre-existing IS26, was precise and conservative and was most efficient when both IS26 could produce an active Tnp26. When both IS were inactivated by a frame-shift in tnp26, TU incorporation was not detected in recA cells, confirming that Tnp26 is required. This novel reaction differs from those of all IS and transposons studied to date. We also investigated the relative contribution of homologous recombination to the generation of a transposon from a TU in RecA+ cells, and found that the Tnp-catalysed reaction was 100-fold more efficient than RecA-dependent homologous recombination. The ability of Tnp26 to function in either a replicative or conservative mode is likely to explain the prominence of IS26-bounded transposons in the resistance regions found in Gram negative bacteria.