The company was fined Â£500 for the incident in July 2015.
It happened at the Islandbank Pumping Station in Newry, County Down.
An inspector saw a "significant volume" of untreated sewage flowing over the wall of the facility and into the canal.
The court was told that during the morning of 13 July, the storm chamber alarms went off at the electronic control centre.
But because they were considered "fleeting" in nature, they were interpreted as an instrument fault.
The alert was not passed on to on-call staff for investigation.
The inspector from the Environment Agency saw sewage related debris on the road and floating in the canal.
Northern Ireland Water was fined under the legislation for making a discharge of sewage effluent to a waterway.
Northern Ireland Water misinterpreted a pollution alarm during a sewage spill because it thought it was a fault, a court has been told.