This paper presents a new condition monitoring system which is capable of monitoring the insulation quality of the stator windings of induction motors. The incipient stage of insulation degradation of only 1.1% turns of a phase winding has been modelled in a finite element program. Experimental setup is also employed in order to verify the proposed modelling technique. The absolute value of the detail coefficient of wavelet decomposition at level 6 is used as a fault indicator for the detection of damage in stator winding insulation. Discrete wavelet transform, finite element analysis along with experimental setup in the laboratory are employed to detect the inter-turn short circuit fault shortly after its occurrence.