diff --git a/src/spec-common/variableSubstitution.ts b/src/spec-common/variableSubstitution.ts
index d973f0cd6..77f8658aa 100644
--- a/src/spec-common/variableSubstitution.ts
+++ b/src/spec-common/variableSubstitution.ts
@@ -83,9 +83,14 @@ function evaluateSingleVariable(replace: Replace, match: string, variable: strin
 	// try to separate variable arguments from variable name
 	let args: string[] = [];
 	const parts = variable.split(':');
-	if (parts.length > 1) {
-		variable = parts[0];
-		args = parts.slice(1);
+	const limitedParts = [
+		...parts.slice(0, 2),
+		parts.slice(2).join(':')
+	];
+	const parts = variable.split(':', 3);
+	if (limitedParts.length > 1) {
+		variable = limitedParts[0];
+		args = limitedParts.slice(1);
 	}
 
 	return replace(match, variable, args);
@@ -168,4 +173,4 @@ function devcontainerIdForLabels(idLabels: Record<string, string>): string {
 		.toString(32)
 		.padStart(52, '0');
 	return uniqueId;
-}
\ No newline at end of file
+}
diff --git a/src/test/variableSubstitution.test.ts b/src/test/variableSubstitution.test.ts
index e95002464..9c2a973d2 100644
--- a/src/test/variableSubstitution.test.ts
+++ b/src/test/variableSubstitution.test.ts
@@ -88,6 +88,21 @@ describe('Variable substitution', function () {
 		assert.strictEqual(result.foo, 'bardefaultbar');
 	});
 
+	it(`environment variables with default value containing colon if they do not exist`, async () => {
+		const raw = {
+			foo: 'bar${localEnv:baz:de:fault}bar'
+		};
+		const result = substitute({
+			platform: 'linux',
+			localWorkspaceFolder: '/foo/bar',
+			containerWorkspaceFolder: '/baz/blue',
+			configFile: URI.file('/foo/bar/baz.json'),
+			env: {
+			},
+		}, raw);
+		assert.strictEqual(result.foo, 'barde:faultbar');
+	});
+
 	it(`environment variables without default value if they do not exist`, async () => {
 		const raw = {
 			foo: 'bar${localEnv:baz}bar'