During fetal development, mammalian back-skin undergoes a natural transition in response to injury, from scarless regeneration to skin scarring. Here, we characterize dermal morphogenesis and follow two distinct embryonic fibroblast lineages, based on their history of expression of the engrailed 1 gene. We use single-cell fate-mapping, live three dimensional confocal imaging and in silico analysis coupled with immunolabelling to reveal unanticipated structural and regional complexity and dynamics within the dermis. We show that dermal development and regeneration are driven by engrailed 1-history-naive fibroblasts, whose numbers subsequently decline. Conversely, engrailed 1-history-positive fibroblasts possess scarring abilities at this early stage and their expansion later on drives scar emergence. The transition can be reversed, locally, by transplanting engrailed 1-naive cells. Thus, fibroblastic lineage replacement couples the decline of regeneration with the emergence of scarring and creates potential clinical avenues to reduce scarring.