Gene silencing by heterochromatin is proposed to occur in part as a result of the ability of heterochromatin protein 1 (HP1) proteins to spread across large regions of the genome, compact the underlying chromatin and recruit diverse ligands. Here we identify a new property of the human HP1α protein: the ability to form phase-separated droplets. While unmodified HP1α is soluble, either phosphorylation of its N-terminal extension or DNA binding promotes the formation of phase-separated droplets. Phosphorylation-driven phase separation can be promoted or reversed by specific HP1α ligands. Known components of heterochromatin such as nucleosomes and DNA preferentially partition into the HP1α droplets, but molecules such as the transcription factor TFIIB show no preference. Using a single-molecule DNA curtain assay, we find that both unmodified and phosphorylated HP1α induce rapid compaction of DNA strands into puncta, although with different characteristics. We show by direct protein delivery into mammalian cells that an HP1α mutant incapable of phase separation in vitro forms smaller and fewer nuclear puncta than phosphorylated HP1α. These findings suggest that heterochromatin-mediated gene silencing may occur in part through sequestration of compacted chromatin in phase-separated HP1 droplets, which are dissolved or formed by specific ligands on the basis of nuclear context.