Modern composite materials have excellent properties that are useful in a wide range of applications. However, the problem of damage tolerance remains an issue, especially in mission‐critical applications. Several approaches for detecting hidden damage have been explored. Herein, a microcapsule‐based system for detecting internal damage is developed and described. Microcapsules containing detection agent fluids are fabricated using microfluidic encapsulation techniques. Each of the two aqueous detection agent fluids is encapsulated separately in two different sets of microcapsules. When mixed into a matrix material, these microcapsules rupture upon damage. This allows the fluids to flow into the damaged areas and react, precipitating magnetic nanoparticles. This facilitates the detection of hidden damage. The microcapsule fabrication techniques are described, and important parameters for successful, consistent encapsulation of the aqueous core fluids are explored. The microcapsules are characterized via a variety of methods. Lastly, the ability of this system to detect surface scratches, fracture, and impact damage is assessed.