Much of the debate in recent studies on Islam and democracy has centered on what has been referred to as the “inclusion-moderation hypothesis” (Schwedler 2006). Does the entrance of ambivalently democratic Islamist parties into the sphere of electoral competition favor the incorporation of those actors into the political sphere, creating democracy “without democrats”(Salamé 1994), or does it empower the lesser democratic elements within those parties to manipulate their newfound political leverage for non-democratic ends? This paper proposes moving beyond this debate and presents a dialectic theoretical model for understanding the interaction between religion-state relationships and processes of democracy in predominantly Islamic societies. As the moderation thesis posits, governments can strengthen the ascent of pragmatic Islamist politicians by empowering Islamist parties to participate in electoral competition and power-sharing coalitions. However, such a strategy also gives such actors a powerful voice over the formation of the moral economy of the country, allowing them to guide the regulation of moral society in ways the state (or western intellectuals) neither desired nor expected. Inviting ambivalently democratic religious actors into the public democratic space, therefore, can produce dialectic dynamics of both “moderate” incorporation into democratic institutions as well as “radical,” illiberal change in the social discourse of society. After presenting the theory, the first part of this paper analyzes the interaction between religion-state relationships and levels of national democracy by using cross-national data on religion-state relationships in the Muslim and Arab world collected by Grim and Finke (2006) and Fox (2006). Then, drawing on original interviews from the field and recent electoral data, the second half of this paper evaluates the mechanisms of the theory by tracing the growth trajectories of two Islamist political parties in Algeria, the MSP and HAMAS, through their strategic responses to government policies of inclusion and the logic of electoral competition.