To overcome the low sensitivity of power transformer partial discharge (PD) detection by a lead zirconate titanate (PZT) sensor, we propose a novel PD detection system based on phase-shifted fiber Bragg gratings (PS-FBG). Compared with the conventional method, the proposed sensor can be installed inside the power transformer, which takes the advantage of the optical fiber status as an insulator. Distributed PD detection is achieved using wavelength and time-division multiplexing. Frequency response experiments indicate that the sensitivity of the PS-FBG is 8.46 dB higher than that of the conventional ultrasonic sensor. Moreover, a PD detection experiment shows that the PD sensitivity of the PS-FBG immersed in oil is 17.5 times higher than that of the PZT sensor. Furthermore, the multiplexing and the feasibility of defect localization of the proposed distributed PD detection system are demonstrated.