A nonlinear stability method is developed for laminar two-fluid shear flows which undergo changes in the interface topology. The method is based on the nonlinear parabolized stability equations (PSE) and incorporates a scalar-based interface capturing (IC) scheme in order to track complex deformations of the fluid interface. In doing so, the formulation retains the flexibility and physical insight of instability-wave based methods, while providing hydrodynamic modeling capabilities similar to direct numerical calculations: the new formulation, referred to as the IC-PSE, can capture the nonlinear physical mechanisms responsible for generating large-scale, two-fluid structures, without incurring heavy computational costs. This approach is valid for spatially developing, laminar two-fluid shear flows which are convectively unstable, and can naturally account for the growth of finite amplitude interfacial waves, along with changes to the interfacial topology. We demonstrate the accuracy of the IC-PSE against direct Navier–Stokes calculations for two-fluid mixing layers with density and viscosity stratification. The comparisons show that the IC-PSE can predict the dynamics of the instability waves and capture the formation of Kelvin–Helmholtz vortex rolls and large scale liquid structures, at an order of magnitude less computational cost than direct calculations. The role of surface tension in the IC-PSE formulation is shown to be valid for flows in which Re/We ≲ 1, and the method accurately predicts the formation and non-linear evolution of flow structures in this limit. This is demonstrated for spatially developing mixing layers which lead to vortex roll-up and ligaments, prior to droplet formation. The pinch-off process itself is a high surface tension phenomenon and in not considered herein. The method also accurately captures the effect of interfacial waves on the mean flow, and the topology changes during the non-linear evolution of the two-fluid structures.