This paper analyses the islanded operations of the photovoltaic (PV) microgrid system with a designed smart voltage source inverter (VSI) for extreme and real life operations, for example, under random load variations, external severe faults, and stochastic radiation variations. The designed VSI for the PV system is modified to effectively supply the real and reactive powers both in grid-tied and islanded modes. In this proposed design, the VSI controller requires minimal modification for reference transfer from grid-tied to islanding mode and vice versa. The designed microgrid system is analyzed in PSCAD/EMTDC software environment and implemented in the real distribution network from Energex. The designed VSI shows robust fault recovery and faster oscillation damping even during islanded condition as well as transfers reference smoothly between operating modes without causing severe delays or disturbances in the distribution network.