This paper presents the problem of fault diagnosis in a three-tank hydraulic system. A mathematical model of the system is developed in order to apply two different observing algorithms. Unknown Input Observer (UIO) and Extended Kalman Filter (EKF) have been used to detect and isolate actuator and sensor faults. For Unknown Input Observer (UIO), residuals are calculated from the measured and estimated output according to the eigenvalues of the system after processed by Linear Matrix Inequality (LMI). Extended Kalman filter uses process and measurement noise variances for state estimation. Unknown Input Observer and Extended Kalman Filter's performance in fault estimation and isolation is evaluated under different scenarios. Using Extended Kalman Filter (EKF), faults can be diagnosed effectively in the presence of noise, while Unknown Input Observer (UIO) is working better in the absence of noise, and simulation results illustrate that clearly.