RNA-catalyzed lariat formation is present in both eukaryotes and prokaryotes. To date we lack structural insights into the catalytic mechanism of lariat-forming ribozymes. Here, we study an artificial 2'-5' AG1 lariat-forming ribozyme that shares the sequence specificity of lariat formation with the pre-mRNA splicing reaction. Using NMR, we solve the structure of the inactive state of the ribozyme in the absence of magnesium. The reaction center S'-guanosine appears to be part of a helix with an exceptionally widened major groove, while the lariat-forming A48 is looped out at the apex of a pseudoknot. The model of the active state built by mutational analysis, molecular modeling, and small-angle X-ray scattering suggests that A48 is recognized by a conserved adenosine, juxtaposed to the 5'-guanosine in one base-pair step distance, while the G1-N7 coordinates a magnesium ion essential for the activation of the nucleophile. Our findings offer implications for lariat formation in RNA enzymes including the mechanism of the recognition of the branch-site adenosine.