Terpenoid natural products comprise a wide range of molecular architectures that typically result from C-C bond formations catalysed by classical type I/II terpene cyclases. However, the molecular diversity of biologically active terpenoids is substantially increased by fully unrelated, non-canonical terpenoid cyclases. Their evolutionary origin has remained enigmatic. Here we report the in vitro reconstitution of an unusual flavin-dependent bacterial indoloterpenoid cyclase, XiaF, together with a designated flavoenzyme-reductase (XiaP) that mediates a key step in xiamycin biosynthesis. The crystal structure of XiaF with bound FADH2 (at 2.4 Å resolution) and phylogenetic analyses reveal that XiaF is, surprisingly, most closely related to xenobiotic-degrading enzymes. Biotransformation assays show that XiaF is a designated indole hydroxylase that can be used for the production of indigo and indirubin. We unveil a cryptic hydroxylation step that sets the basis for terpenoid cyclization and suggest that the cyclase has evolved from xenobiotics detoxification enzymes.