Poly(lactide-co-glycolide) (PLG), a biocompatible and biodegradable polymer, is dramatically toughened by adding small amounts of surface modified clay nanoparticles. The elongation during tensile tests increases from 7% for the pure polymer to 210% for the nanocomposite, accompanied with a modest increase in modulus. In contrast, PLG nanocomposites based on fumed silica treated with hexamethyldisilazane show only modest improvements in toughness. Electron microscopy, X-ray scattering, rheometry, and dielectric relaxation spectroscopy are used to investigate the toughening mechanism. Multiple crazing occurs in the clay nanocomposite after yielding. Small angle X-ray scattering studies show significant orientation of the clay nanoparticles along the tensile stress direction during deformation. The clay nanocomposites show a new, slow relaxation mode, most likely due to interfacial adsorbption of PLG chains on the surface of the clay nanoparticles. The dramatic increase in toughness is attributed to physical crosslinks introduced by the clay nanoparticles, a mechanism absent in the PLG/silica nanocomposites. The physical crosslinks increase the brittle fracture strength of the polymer and, consequently, trigger a toughening mechanism via multiple crazing and shear yielding.