Due to low system inertia in microgrids, frequencies may vary rapidly from the nominal value, leading to the complete blackout of the system unless there is an adequate spinning reserve available for balancing the supply with the demand load. This issue of instability in microgrids under islanded operation has attracted particular attention recently. A diesel generator is considered to be an ideal spinning reserve to provide back-up power to the load along with the renewable energy source in islanded system. However, the high maintenance cost and CO2 emissions of diesel generator are detrimental factors which have inspired searches for more cost effective and cleaner technologies. The integration of an energy storage system (ESS) in islanded system along with generator not only reduces generator maintenance costs but also reduces the CO2 emissions by limiting its operating hours. This paper proposes an islanded PV hybrid microgrid system (PVHMS) utilizing flywheel energy storage systems (FESS) as an alternative to battery technology to support the PV system and meet the peak demand of a small residential town with 100 dwellings. The diesel generator is used in the islanded system as a spinning reserve to maintain the stability of the islanded system when the PV system and flywheel storage cannot meet the load demand. Results of analysis of such a system demonstrate that flywheel energy storage technology of appropriate size offers a viable solution to support the operation of the standalone PV system. Furthermore, the reduction in CO2 emissions and fuel consumption has been quantified as compared with the case with flywheel energy storage systems which means the diesel generator but always be operating.