The invention provides a passive filter with lightning-protection isolation and arc detection functions and a method thereof. The passive filter is a safety electrical device with ground potential counterattack isolation, fault arc detection, harmonic current suppression and three-phase unbalanced current compensation functions, wherein the current detection of fault arc and the current detection part of harmonic current suppression and compensation are shared, a same detection signal is adopted, and a common main control unit is used for simultaneously analyzing the fault arc and computing compensation command current, so that the device can sample a fault arc feature current before the fault arc feature current is filtered out, and accurate detection of the fault arc is ensured. The method uses a judgment result of a current difference parameter as a premise, and uses a change rare of a harmonic ratio to judge the fault arc, so that interference of a nonlinear load can be effectively excluded, meanwhile, four kinds of judgment means are used for judging, and thus the fault arc can be accurately detected.