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This paper describes an observer-based air fraction estimation method for diesel engines with dual-loop exhaust gas recirculation (EGR) systems to conduct multiple and alternative combustion modes for significant engine emission reduction. An observer is designed to estimate the air fractions in all the engine intake/exhaust sections using standard sensors equipped on the engines. The observer provides indispensable information for the engine controller to exercise closed-loop control on in-cylinder conditions, in particular the high-pressure EGR gas and low-pressure EGR gas amounts and the ratio, which are crucial for engines running alternative combustion modes with dual- loop EGR systems. The convergence stability of the observer is proved based on a Lyapunov analysis assisted by physical insights into the engine systems. The observer is also experimentally evaluated on a modern light-duty diesel engine with a dual-loop EGR system.