In order to establish a stable fiber grating sensor wavelength demodulation system, we use narrow band filter characteristic of tunable Fabry-Perot filter to make a linear scan of broadband light source, and use a high-precision reference grating placed in a thermostat to calibrate Fabry-Perot etalon, and to provide multiple wavelength reference points with the same interval and stable amplitude. The original data sequence is modified by the improved wavelet threshold denoising algorithm(using a new threshold function and a new threshold). We gain raw peak sequence by the core idea of the Gaussian fitting algorithm, and then do the secondary treatment, remove some invalid peaks, modify location of part peaks, and build a fiber grating displacement sensor real-time monitoring and demodulation system. Compared with spiral micrometer, accuracy of this system is about 0.25 mm.