Tissue regeneration is a multi-step process mediated by diverse cellular hierarchies and states that are also implicated in tissue dysfunction and pathogenesis. Here, we leveraged single-cell RNA sequencing in combination with in vivo lineage tracing and organoid models to finely map the trajectories of alveolar lineage cells during injury repair and lung regeneration. We identified a distinct AT2-lineage population, Damage-Associated Transient Progenitors (DATPs), that arises during alveolar regeneration. We found that interstitial macrophage-derived IL-1β primes a subset of AT2 cells expressing Il1r1 for conversion into DATPs via a HIF1α-mediated glycolysis pathway, which is required for mature AT1 cell differentiation. Importantly, chronic inflammation mediated by IL-1β prevents AT1 differentiation, leading to aberrant accumulation of DATPs and impaired alveolar regeneration. Together, this step-wise mapping to cell fate transitions shows how an inflammatory niche impairs alveolar regeneration by controlling stem cell fate and behavior. Overall design: For this scRNA-seqeuncing, AT2 cells were isolated from Sftpc-CreERT2;R26RTomato mice treated with tamoxifen and lung organoids derived from AT2 cells isolated from SPC-CreERT2;R26RTomato mice were established for 2 weeks in co-culture with stromal cells. The expression levels were quantified using the Chromium Controller (10X Genomics).