We describe the successful application of a new method to estimate permeability and permeability anisotropy from transient measurements of pressure acquired with a wireline straddle-packer formation tester. Unlike standard algorithms used for the interpretation of formation-tester measurements, the method developed in this paper incorporates the physics of two-phase immiscible flow as well as the processes of mudcake buildup and invasion. An efficient 2D (cylindrical coordinates) implicit-pressure explicit-saturation finite-difference algorithm is used to simulate both the process of invasion and the pressure measurements acquired with the straddle-packer formation tester. Initial conditions for the simulation of formation-tester measurements are determined by the spatial distributions of pressure and fluid saturation resulting from mud-filtrate invasion. Inversion is performed with a Levenberg-Marquardt nonlinear minimization algorithm. Sensitivity analyses are conducted to assess nonuniqueness and the impact of explicit assumptions made about fluid viscosity, capillary pressure, relative permeability, mudcake growth, and time of invasion on the estimated values of permeability and permeability anisotropy. Applications of the inversion method to noisy synthetic measurements include homogeneous, anisotropic, single- and multi-layer formations for cases of low- and high-permeability rocks. We also study the effect of unaccounted impermeable bed boundaries on inverted formation properties. For cases where a priori information can be sufficiently constrained, our inversion methodology provides reliable and accurate estimates of permeability and permeability anisotropy. In addition, we show that estimation errors of permeability inversion procedures that neglect the physics of two-phase immiscible fluid flow and mud-filtrate invasion can be as high as 100%.