This paper presents an algorithm based on a combination of Discrete Wavelet Transforms and neural networks for detection and classification of internal faults in a two-winding three-phase transformer. Fault conditions of the transformer are simulated using ATP/EMTP in order to obtain current signals. The training process for the neural network and fault diagnosis decision are implemented using toolboxes on MATLAB/Simulink. Various cases and fault types based on Thailand electricity transmission and distribution systems are studied to verify the validity of the algorithm. It is found that the proposed method gives a satisfactory accuracy, and will be particularly useful in a development of a modern differential relay for a transformer protection scheme.