Trimethylamine n-oxide (TMAO) is a naturally occurring osmolyte that stabilizes proteins and offsets the destabilizing effects of urea. To investigate the molecular mechanism of these effects, we have studied the thermodynamics of interaction between TMAO and protein functional groups. The solubilities of a homologous series of cyclic dipeptides were measured by differential refractive index and the dissolution heats were determined calorimetrically as a function of TMAO concentration at 25 degreesC. The transfer free energy of the amide unit (-CONH-) from water to 1 M TMAO is large and positive, indicating an unfavorable interaction between the TMAO solution and the amide unit. This unfavorable interaction is enthalpic in origin. The interaction between TMAO and apolar groups is slightly favorable. The transfer free energy of apolar groups from water to TMAO consists of favorable enthalpic and unfavorable entropic contributions. This is in contrast to the contributions for the interaction between urea and apolar groups. Molecular dynamics simulations were performed to provide a structural framework for the interpretation of these results. The simulations show enhancement of water structure by TMAO in the form of a slight increase in the number of hydrogen bonds per water molecule, stronger water hydrogen bonds, and long-range spatial ordering of the solvent. These findings suggest that TMAO stabilizes proteins via enhancement of water structure, such that interactions with the amide unit are discouraged.