An approach for diagnosis and mitigation of sensor malfunctioning in a permanent magnet synchronous generator based direct-drive variable speed wind energy conversion system (WECS) is presented in this paper. Malfunctioning of current sensors causes erroneous grid- and machine-side current measurements, which significantly affect the operation of grid- and machine-side controllers, and in turn, performance of the WECS system degrades. In the proposed approach, the sliding-mode observer-based fault diagnosis theory is used to diagnose (i.e., to detect and estimate) the error induced in the grid- and machine-side current measurements due to sensor malfunctioning. The proposed mitigation action rectifies the measured grid- and machine-side currents using estimated measurement errors, as soon as malfunctioning of sensors is diagnosed, and ensures resilient operation of the WECS against sensor malfunctioning. The accuracy and effectiveness of the proposed approach are verified through rigorous simulation and experimental studies, which clearly demonstrate the effectiveness of the proposed approach.