The degradation mechanism of water contaminated Automatic Transmission Fluids (ATF) was experimentally investigated. Water contaminated ATF was tribotested in a full-scale wet clutch test rig to monitor the friction durability during clutch ageing, and was also statically aged in oven to evaluate the interaction of ATF with water. The bulk properties and chemical nature of the ATF were analysed using viscosity measurements, Fourier Transform Infrared Spectroscopy (FTIR) and Thermogravimetric Analysis (TGA). It was shown that water presence in the ATF can increase the mean friction coefficient over a short time period, though in the long term perspective there is a higher loss of mean friction. Phase separation of the water-in-oil emulsion by centrifugation at 20000 rpm made it possible to examine the water phase using infrared 2spectroscopy. The spectroscopic analysis revealed the hydrophilic nature of certain ATF constituents, although the impact of water on the bulk properties like lubricant viscosity and thermal stability was insignificant. The analysis of the tribotests showed that the friction increase for water contamination was a short-term effect and likely due to the interaction between polar surface active additives and water. Even though no significant change has been found for thermal degradation or in bulk properties of the lubricant, the initially changed action of the water soluble additives and generation of high friction resulted in a total deterioration of the clutch performance during long term use.