In compression systems the stable operating range is limited by rotating stall and/or surge. Two distinct types of stall precursors can be observed prior to full scale instability: the development of long-wavelength modal waves or a short-wavelength, three-dimensional flow breakdown (so-called “spike” stall inception). The cause of the latter is not well understood; in axial machines it has been suggested that rotor blade-tip leakage flow plays an important role, but spikes have recently been observed in shrouded vaned diffusers of centrifugal compressors where these leakage flows are not present, suggesting an alternative mechanism may be at play. This paper investigates the onset of instability in a shrouded vaned diffuser from a highly loaded turbocharger centrifugal compressor and discusses the mechanisms thought to be responsible for the development of short-wavelength stall precursors. The approach combines unsteady 3D RANS simulations of an isolated vaned diffuser with previously obtained experimental results. The unsteady flow field simulation begins at the impeller exit radius, where flow is specified by a spanwise profile of flow angle and stagnation properties, derived from single-passage stage calculations but with flow pitchwise mixed. Through comparison with performance data from previous experiments and unsteady full-wheel simulations, it is shown that the diffuser is accurately matched to the impeller and the relevant flow features are well captured. Numerical forced response experiments are carried out to determine the diffuser dynamic behavior and point of instability onset. The unsteady simulations demonstrate the growth of short-wavelength precursors; the flow coefficient at which these occur, the rotation rate and circumferential extent agree with experimental measurements. Although the computational setup and domain limitations do not allow simulation of the fully developed spike nor full-scale instability, the model is sufficient to capture the onset of instability and allows the postulation of the following necessary conditions: (i) flow separation at the diffuser vane leading edge near the shroud endwall; (ii) radially reversed flow allowing vorticity shed from the leading edge to convect back into the vaneless space; and (iii) recirculation and accumulation of low stagnation pressure fluid in the vaneless space, increasing diffuser inlet blockage and leading to instability. Similarity exists with axial machines, where blade-tip leakage sets up endwall flow in the circumferential direction leading to flow breakdown and the inception of rotating stall. Rather than the tip leakage flows, the cause for circumferential endwall flow in the vaned diffuser is the combination of high swirl and the highly non-uniform spanwise flow profile at the impeller exit.