Context processing is a cognitive construct associated with activity in the middle frontal gyrus. Schizophrenia-related deficits in context processing tasks have been associated with prefrontal cortical dysfunction. This study evaluated whether prefrontal cortical dysfunction related to context processing occurred in first-episode, never-medicated schizophrenia patients, whether this dysfunction also occurred in patients with nonschizophrenia psychosis, and whether this dysfunction was related to psychotic symptom expression. A modified version of the AX continuous performance task was conducted during event-related functional magnetic resonance imaging in 18 never-medicated, first-episode schizophrenia patients, 12 never-medicated patients with first-episode nonschizophrenia psychosis, and 28 comparison participants without psychiatric disorder. In-scanner measures of errors and interference reaction time showed that the schizophrenia patients had a specific deficit in context processing. Trials with greater context processing demands corresponded to activity in the middle frontal gyrus (Brodmann’s area 9) in the comparison subjects and in the patients with nonschizophrenia psychosis, but not in the schizophrenia patients. Individual differences in prefrontal cortical dysfunction were associated with context processing measures and disorganization symptoms. The schizophrenia patients also showed increased activity in the anterior (Brodmann’s area 10) and inferior prefrontal cortices (Brodmann’s area 45/46) when they were maintaining context over a delay. Prefrontal dysfunctions related to context processing were found only in schizophrenia patients early in the course of the illness, and these dysfunctions were related to disorganization symptoms. Instead of using context processing during a continuous performance task, schizophrenia patients may use an inefficient encoding and retrieval strategy.