Health monitoring of large structures with embedded, distributed sensor systems is gaining importance. This study proposes a new probabilistic model updating method in order to improve the damage prediction capability of a finite element analysis (FEA) model with experimental observations from a Lamb-wave sensing system. The approach statistically calibrates unknown parameters of the FEA model and estimates a bias-correcting function to achieve a good match between the model predictions and sensor observations. An experimental validation study is presented in which a set of controlled damages are generated on a composite panel. Time-series signals are collected with the damage condition using a Lamb-wave sensing system and a one dimensional FEA model of the panel is constructed to quantify the damages. The damage indices from both the experiments and the computational model are used to calibrate assumed parameters of the FEA model and to estimate a bias-correction function. The updated model is used to predict the size (extent) and location of damage. It is shown that the proposed model updating approach achieves a prediction accuracy that is superior to a purely statistical approach or a deterministic model calibration approach.