diff --git a/src/errors.h b/src/errors.h
index 6346bf2..3c76bb7 100644
--- a/src/errors.h
+++ b/src/errors.h
@@ -355,8 +355,7 @@
 	INIT(= N_("E1084: Cannot delete Vim9 script function %s"));
 EXTERN char e_not_callable_type_str[]
 	INIT(= N_("E1085: Not a callable type: %s"));
-EXTERN char e_cannot_use_function_inside_def[]
-	INIT(= N_("E1086: Cannot use :function inside :def"));
+// E1086 unused
 EXTERN char e_cannot_use_index_when_declaring_variable[]
 	INIT(= N_("E1087: Cannot use an index when declaring a variable"));
 // E1088 unused
diff --git a/src/structs.h b/src/structs.h
index bef7062..48a531b 100644
--- a/src/structs.h
+++ b/src/structs.h
@@ -1699,6 +1699,7 @@
 #define FC_VIM9	    0x400	// defined in vim9 script file
 #define FC_CFUNC    0x800	// defined as Lua C func
 #define FC_COPY	    0x1000	// copy of another function by copy_func()
+#define FC_LAMBDA   0x2000	// one line "return {expr}"
 
 #define MAX_FUNC_ARGS	20	// maximum number of function arguments
 #define VAR_SHORT_LEN	20	// short variable name length
diff --git a/src/testdir/test_vim9_func.vim b/src/testdir/test_vim9_func.vim
index 34f84f2..51b95ab 100644
--- a/src/testdir/test_vim9_func.vim
+++ b/src/testdir/test_vim9_func.vim
@@ -586,15 +586,19 @@
 enddef
 
 def Test_nested_function()
-  def Nested(arg: string): string
+  def NestedDef(arg: string): string
     return 'nested ' .. arg
   enddef
-  Nested('function')->assert_equal('nested function')
+  NestedDef(':def')->assert_equal('nested :def')
+
+  func NestedFunc(arg)
+    return 'nested ' .. a:arg
+  endfunc
+  NestedFunc(':func')->assert_equal('nested :func')
 
   CheckDefFailure(['def Nested()', 'enddef', 'Nested(66)'], 'E118:')
   CheckDefFailure(['def Nested(arg: string)', 'enddef', 'Nested()'], 'E119:')
 
-  CheckDefFailure(['func Nested()', 'endfunc'], 'E1086:')
   CheckDefFailure(['def s:Nested()', 'enddef'], 'E1075:')
   CheckDefFailure(['def b:Nested()', 'enddef'], 'E1075:')
 
@@ -705,6 +709,26 @@
   lines =<< trim END
       vim9script
       def Outer()
+          func g:Inner()
+            return 'inner'
+          endfunc
+      enddef
+      defcompile
+      Outer()
+      g:Inner()->assert_equal('inner')
+      delfunc g:Inner
+      Outer()
+      g:Inner()->assert_equal('inner')
+      delfunc g:Inner
+      Outer()
+      g:Inner()->assert_equal('inner')
+      delfunc g:Inner
+  END
+  CheckScriptSuccess(lines)
+
+  lines =<< trim END
+      vim9script
+      def Outer()
           def g:Inner(): string
               return 'inner'
           enddef
diff --git a/src/userfunc.c b/src/userfunc.c
index 602d3b7..c961115 100644
--- a/src/userfunc.c
+++ b/src/userfunc.c
@@ -523,7 +523,7 @@
     fp->uf_def_status = UF_NOT_COMPILED;
     fp->uf_refcount = 1;
     fp->uf_varargs = TRUE;
-    fp->uf_flags = FC_CFUNC;
+    fp->uf_flags = FC_CFUNC | FC_LAMBDA;
     fp->uf_calls = 0;
     fp->uf_script_ctx = current_sctx;
     fp->uf_cb = cb;
@@ -1205,6 +1205,7 @@
     set_ufunc_name(ufunc, name);
     if (hash_add(&func_hashtab, UF2HIKEY(ufunc)) == FAIL)
 	goto erret;
+    ufunc->uf_flags = FC_LAMBDA;
     ufunc->uf_refcount = 1;
     ufunc->uf_args = *newargs;
     newargs->ga_data = NULL;
@@ -1399,7 +1400,7 @@
     if (evaluate)
     {
 	int	    len;
-	int	    flags = 0;
+	int	    flags = FC_LAMBDA;
 	char_u	    *p;
 	char_u	    *line_end;
 	char_u	    *name = get_lambda_name();
@@ -2506,8 +2507,7 @@
 	return;
     }
 
-    if (STRNCMP(fp->uf_name, "<lambda>", 8) == 0)
-	islambda = TRUE;
+    islambda = fp->uf_flags & FC_LAMBDA;
 
     /*
      * Note about using fc->fixvar[]: This is an array of FIXVAR_CNT variables
diff --git a/src/version.c b/src/version.c
index e7f2c74..90021be 100644
--- a/src/version.c
+++ b/src/version.c
@@ -758,6 +758,8 @@
 static int included_patches[] =
 {   /* Add new patch number below this line */
 /**/
+    3692,
+/**/
     3691,
 /**/
     3690,
diff --git a/src/vim9.h b/src/vim9.h
index cffa71b..88c0469 100644
--- a/src/vim9.h
+++ b/src/vim9.h
@@ -322,7 +322,8 @@
 
 // arguments to ISN_FUNCREF
 typedef struct {
-    int		fr_func;	// function index
+    int		fr_dfunc_idx;	// function index for :def function
+    char_u	*fr_func_name;	// function name for legacy function
 } funcref_T;
 
 // arguments to ISN_NEWFUNC
diff --git a/src/vim9compile.c b/src/vim9compile.c
index fe692cb..2c4e203 100644
--- a/src/vim9compile.c
+++ b/src/vim9compile.c
@@ -1675,7 +1675,10 @@
     RETURN_OK_IF_SKIP(cctx);
     if ((isn = generate_instr(cctx, ISN_FUNCREF)) == NULL)
 	return FAIL;
-    isn->isn_arg.funcref.fr_func = ufunc->uf_dfunc_idx;
+    if (ufunc->uf_def_status == UF_NOT_COMPILED)
+	isn->isn_arg.funcref.fr_func_name = vim_strsave(ufunc->uf_name);
+    else
+	isn->isn_arg.funcref.fr_dfunc_idx = ufunc->uf_dfunc_idx;
     cctx->ctx_has_closure = 1;
 
     // If the referenced function is a closure, it may use items further up in
@@ -5835,6 +5838,7 @@
     fill_exarg_from_cctx(eap, cctx);
 
     eap->forceit = FALSE;
+    // We use the special <Lamba>99 name, but it's not really a lambda.
     lambda_name = vim_strsave(get_lambda_name());
     if (lambda_name == NULL)
 	return NULL;
@@ -9976,16 +9980,11 @@
 	switch (ea.cmdidx)
 	{
 	    case CMD_def:
+	    case CMD_function:
 		    ea.arg = p;
 		    line = compile_nested_function(&ea, &cctx);
 		    break;
 
-	    case CMD_function:
-		    // TODO: should we allow this, e.g. to declare a global
-		    // function?
-		    emsg(_(e_cannot_use_function_inside_def));
-		    goto erret;
-
 	    case CMD_return:
 		    line = compile_return(p, check_return_type,
 				 local_cmdmod.cmod_flags & CMOD_LEGACY, &cctx);
@@ -10442,12 +10441,23 @@
 
 	case ISN_FUNCREF:
 	    {
-		dfunc_T *dfunc = ((dfunc_T *)def_functions.ga_data)
-					       + isn->isn_arg.funcref.fr_func;
-		ufunc_T *ufunc = dfunc->df_ufunc;
+		if (isn->isn_arg.funcref.fr_func_name == NULL)
+		{
+		    dfunc_T *dfunc = ((dfunc_T *)def_functions.ga_data)
+					   + isn->isn_arg.funcref.fr_dfunc_idx;
+		    ufunc_T *ufunc = dfunc->df_ufunc;
 
-		if (ufunc != NULL && func_name_refcount(ufunc->uf_name))
-		    func_ptr_unref(ufunc);
+		    if (ufunc != NULL && func_name_refcount(ufunc->uf_name))
+			func_ptr_unref(ufunc);
+		}
+		else
+		{
+		    char_u *name = isn->isn_arg.funcref.fr_func_name;
+
+		    if (name != NULL)
+			func_unref(name);
+		    vim_free(isn->isn_arg.funcref.fr_func_name);
+		}
 	    }
 	    break;
 
diff --git a/src/vim9execute.c b/src/vim9execute.c
index 5593f58..7704635 100644
--- a/src/vim9execute.c
+++ b/src/vim9execute.c
@@ -3168,8 +3168,8 @@
 	    case ISN_FUNCREF:
 		{
 		    partial_T   *pt = ALLOC_CLEAR_ONE(partial_T);
-		    dfunc_T	*pt_dfunc = ((dfunc_T *)def_functions.ga_data)
-					       + iptr->isn_arg.funcref.fr_func;
+		    ufunc_T	*ufunc;
+		    funcref_T	*funcref = &iptr->isn_arg.funcref;
 
 		    if (pt == NULL)
 			goto theend;
@@ -3178,8 +3178,18 @@
 			vim_free(pt);
 			goto theend;
 		    }
-		    if (fill_partial_and_closure(pt, pt_dfunc->df_ufunc,
-								 ectx) == FAIL)
+		    if (funcref->fr_func_name == NULL)
+		    {
+			dfunc_T	*pt_dfunc = ((dfunc_T *)def_functions.ga_data)
+						       + funcref->fr_dfunc_idx;
+
+			ufunc = pt_dfunc->df_ufunc;
+		    }
+		    else
+		    {
+			ufunc = find_func(funcref->fr_func_name, FALSE, NULL);
+		    }
+		    if (fill_partial_and_closure(pt, ufunc, ectx) == FAIL)
 			goto theend;
 		    tv = STACK_TV_BOT(0);
 		    ++ectx->ec_stack.ga_len;
@@ -5454,10 +5464,17 @@
 	    case ISN_FUNCREF:
 		{
 		    funcref_T	*funcref = &iptr->isn_arg.funcref;
-		    dfunc_T	*df = ((dfunc_T *)def_functions.ga_data)
-							    + funcref->fr_func;
+		    char_u	*name;
 
-		    smsg("%s%4d FUNCREF %s", pfx, current, df->df_ufunc->uf_name);
+		    if (funcref->fr_func_name == NULL)
+		    {
+			dfunc_T	*df = ((dfunc_T *)def_functions.ga_data)
+						       + funcref->fr_dfunc_idx;
+			name = df->df_ufunc->uf_name;
+		    }
+		    else
+			name = funcref->fr_func_name;
+		    smsg("%s%4d FUNCREF %s", pfx, current, name);
 		}
 		break;