This paper presents a control method for inverter operations in an islanded distributed generation system. The control system has to provide sufficient active and reactive power to match the connected load, therein providing high power quality. The control system in this mode is based on the voltage and frequency droop. A detailed analysis, based on the concept of harmonic impedance, establishes the appropriateness of capacitor current feedback versus inductor current feedback with respect to inverter power quality. A steepest descent adaptive control for the output voltage has been embedded in the control system to estimate the output voltage for sensorless operation to enhance the system reliability and performance. To compensate the calculation delay in the DSP, a modified Kalman filter design is discussed. Simulation and experimental results are provided to demonstrate the validity of the proposed control method.