Telomerase is a ribonucleoprotein (RNP) required for maintenance of telomeres. Although up-regulated telomerase activity is closely linked to the cellular immortality characteristic of late stage carcinogenesis, recently, mutations in the telomerase RNA gene in humans have been associated with dyskeratosis congenita and aplastic anemia, both typified by impaired haemopoietic function. These mutations include base changes in a highly conserved putative telomerase RNA pseudoknot. Here, by using in vitro telomerase assays, NMR, and UV absorbance melting analyses of model oligonucleotides designed to form a "trans-pseudoknot," we describe functional, structural, and energetic properties of this structure. We demonstrate that the pseudoknot domain exists in two alternative states of nearly equal stability in solution: one is the previously proposed pseudoknot formed by pairing P3 with the loop domain of P2b, and the other is a structured P2b loop alone. We show that the two-base mutation (GC1078 --> AG) present in one gene copy in a family with dyskeratosis congenita abrogates telomerase activity. This mutation hyperstabilizes the P2b intraloop structure, blocking pseudoknot formation. Conversely, when the P3 pseudoknot pairing is hyperstabilized by deleting a conserved bulge in P3, telomerase activity also decreases. We propose that the P2bP3 pseudoknot domain acts as a molecular switch, and interconversion between its two states is important for telomerase function. Phylogenetic covariation in the P2b and P3 sequences of 35 species provides a compelling set of "natural" compensatory base pairing changes supporting the existence of the crucial molecular switch.