Children with Asperger's syndrome show deficits in social functioning while their intellectual and language development is intact suggesting a specific dysfunction in mechanisms mediating social cognition. An action observation/execution matching system might be one such mechanism. Recent studies indeed showed that electrophysiological modulation of the “Mu-rhythm” in the 10–12 Hz range is weaker when individuals with Asperger's syndrome observe actions performed by others compared to controls. However, electrophysiological studies typically fall short in revealing the neural generators of this activity. To fill this gap we assessed magnetoencephalographic Mu-modulations in Asperger's and typically developed children, while observing grasping movements. Mu-power increased at frontal and central sensors during movement observation. This modulation was stronger in typical than in Asperger children. Source localization revealed stronger sources in premotor cortex, the intraparietal lobule (IPL) and the mid-occipito-temporal gyrus (MOTG) and weaker sources in prefrontal cortex in typical participants compared to Asperger. Activity in premotor regions, IPL and MOTG correlated positively with social competence, whereas prefrontal Mu-sources correlated negatively with social competence. No correlation with intellectual ability was found at any of these sites. These findings localize abnormal Mu-activity in the brain of Asperger children providing evidence which associates motor-system abnormalities with social-function deficits.