diff --git a/e2e/tests/up/provider_docker.go b/e2e/tests/up/provider_docker.go
index 8cd5aaf9a..56e95a7b2 100644
--- a/e2e/tests/up/provider_docker.go
+++ b/e2e/tests/up/provider_docker.go
@@ -175,6 +175,50 @@ var _ = ginkgo.Describe(
 			gomega.Expect(customImage).To(gomega.Equal("alpine:latest"))
 		}, ginkgo.SpecTimeout(framework.GetTimeout()))
 
+		ginkgo.It("variable substitution with defaults", func(ctx context.Context) {
+			tempDir, err := dtc.setupAndUp(
+				ctx, "tests/up/testdata/docker-variables-defaults",
+			)
+			framework.ExpectNoError(err)
+
+			workspace, err := dtc.f.FindWorkspace(ctx, tempDir)
+			framework.ExpectNoError(err)
+
+			ids, err := dtc.findWorkspaceContainer(ctx, workspace)
+			framework.ExpectNoError(err)
+			gomega.Expect(ids).To(gomega.HaveLen(1))
+
+			// Unset var uses simple default
+			withDefault, err := dtc.execSSHCapture(
+				ctx, workspace.ID,
+				"cat $HOME/with-default.out",
+			)
+			framework.ExpectNoError(err)
+			gomega.Expect(withDefault).To(
+				gomega.Equal("my_default_value"),
+			)
+
+			// Unset var uses default containing colons
+			colonDefault, err := dtc.execSSHCapture(
+				ctx, workspace.ID,
+				"cat $HOME/colon-default.out",
+			)
+			framework.ExpectNoError(err)
+			gomega.Expect(colonDefault).To(
+				gomega.Equal("http://proxy:8080"),
+			)
+
+			// Set var ignores default
+			setVar, err := dtc.execSSHCapture(
+				ctx, workspace.ID,
+				"cat $HOME/set-var.out",
+			)
+			framework.ExpectNoError(err)
+			gomega.Expect(setVar).To(
+				gomega.Equal(os.Getenv("HOME")),
+			)
+		}, ginkgo.SpecTimeout(framework.GetTimeout()))
+
 		ginkgo.It("mounts", func(ctx context.Context) {
 			tempDir, err := dtc.setupAndUp(ctx, "tests/up/testdata/docker-mounts", "--debug")
 			framework.ExpectNoError(err)
diff --git a/e2e/tests/up/testdata/docker-variables-defaults/.devcontainer.json b/e2e/tests/up/testdata/docker-variables-defaults/.devcontainer.json
new file mode 100644
index 000000000..76663147e
--- /dev/null
+++ b/e2e/tests/up/testdata/docker-variables-defaults/.devcontainer.json
@@ -0,0 +1,14 @@
+{
+  "name": "variable-defaults-test",
+  "image": "ghcr.io/devsy-org/test-images/go:1",
+  "remoteEnv": {
+    "WITH_DEFAULT": "${localEnv:VARSUB_NONEXISTENT:my_default_value}",
+    "COLON_DEFAULT": "${localEnv:VARSUB_NONEXISTENT2:http://proxy:8080}",
+    "SET_VAR_IGNORES_DEFAULT": "${localEnv:HOME:fallback}"
+  },
+  "postCreateCommand": [
+    "sh",
+    "-c",
+    "echo -n $WITH_DEFAULT > $HOME/with-default.out && echo -n $COLON_DEFAULT > $HOME/colon-default.out && echo -n $SET_VAR_IGNORES_DEFAULT > $HOME/set-var.out"
+  ]
+}
diff --git a/pkg/devcontainer/config/substitute.go b/pkg/devcontainer/config/substitute.go
index e25f1fba7..2a15dfea3 100644
--- a/pkg/devcontainer/config/substitute.go
+++ b/pkg/devcontainer/config/substitute.go
@@ -155,7 +155,7 @@ func lookupValue(isWindows bool, env map[string]string, args []string, match str
 		}
 
 		if len(args) > 1 {
-			defaultValue := args[1]
+			defaultValue := strings.Join(args[1:], ":")
 			return defaultValue
 		}
 
diff --git a/pkg/devcontainer/config/substitute_test.go b/pkg/devcontainer/config/substitute_test.go
new file mode 100644
index 000000000..d1efceb52
--- /dev/null
+++ b/pkg/devcontainer/config/substitute_test.go
@@ -0,0 +1,77 @@
+package config
+
+import "testing"
+
+func TestLookupValue(t *testing.T) {
+	tests := []struct {
+		name string
+		env  map[string]string
+		args []string
+		want string
+	}{
+		{
+			name: "var set no default",
+			env:  map[string]string{"HOME": "/root"},
+			args: []string{"HOME"},
+			want: "/root",
+		},
+		{
+			name: "var unset no default",
+			env:  map[string]string{},
+			args: []string{"MISSING"},
+			want: "",
+		},
+		{
+			name: "var unset simple default",
+			env:  map[string]string{},
+			args: []string{"MISSING", "fallback"},
+			want: "fallback",
+		},
+		{
+			name: "var unset default with colons",
+			env:  map[string]string{},
+			args: []string{
+				"MISSING", "http",
+				"//proxy.example.com", "8080",
+			},
+			want: "http://proxy.example.com:8080",
+		},
+		{
+			name: "var set default ignored",
+			env:  map[string]string{"VAR": "real"},
+			args: []string{"VAR", "default"},
+			want: "real",
+		},
+	}
+
+	for _, tt := range tests {
+		t.Run(tt.name, func(t *testing.T) {
+			got := lookupValue(
+				false, tt.env, tt.args, "${match}",
+			)
+			if got != tt.want {
+				t.Errorf(
+					"lookupValue() = %q, want %q",
+					got, tt.want,
+				)
+			}
+		})
+	}
+}
+
+func TestResolveStringDefaultWithColons(t *testing.T) {
+	replace := func(_, variable string, args []string) string {
+		env := map[string]string{}
+		return lookupValue(false, env, args, "${"+variable+"}")
+	}
+
+	got := ResolveString(
+		"${localEnv:MISSING:http://x:8080}", replace,
+	)
+	want := "http://x:8080"
+	if got != want {
+		t.Errorf(
+			"ResolveString() = %q, want %q", got, want,
+		)
+	}
+}