This article introduces wavelet analysis theory to identify inrush and internal fault correctly. The wavelet transform has the characteristic of multi-scale analysis and good time and frequency domain localization, fits to extract sudden-change signals in transient processes, and detects irregularity of signals very well. This article analyzes the mechanism of transformer generating excitation inrush, and establishes simulation models of transformer inrush and internal fault. According to different characteristic between inrush and internal fault, choose a proper kind of wavelet to analyze waveforms of inrush and fault current, and mass simulation results show the method can distinguish inrush and internal fault rapidly and accurately.