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 stepwise mapping to cell fate transitions shows how an inflammatory niche controls alveolar regeneration by controlling stem cell fate and behavior.