Distributed control systems (DCSs) with intrinsic and coupling time delays in subsystems are studied, which also have nonlinearities satisfying generalized Lipschitz condition and some unknown parameters. Decoupling of states and parameters is emphasized. The distributed adaptive state observer is then designed for such system. Convergence of observer error dynamics and estimation of unknown parameters is shown based on the solution of Linear Matrix Inequality (LMI) with equality constraints of passivity. The efficacy of the approach is shown through an illustrative example.