The problem of sensor fault diagnosis in the class of nonlinear Lipschitz systems is considered. A dynamic observer structure is used with the objective to make the residual converge to the faults vector achieving detection and estimation at the same time. It is shown that, unlike the classical constant gain structure, this objective is achievable by minimizing the faults effect on the estimation error of the dynamic observer. The use of appropriate weightings to solve the design problem in a standard convex optimization framework is also demonstrated. An LMI design procedure solvable using commercially available software is presented. (c) 2007 Elsevier Ltd. All rights reserved.