The development of modulated structures, martensitic transformation and phase decomposition of austenitic Fe-7wt.% Al-1.8wt.%C steel has been studied by transmission electron microscopy and X-ray diffraction. The solution treated specimens are austenitic but inhomogeneous to the extent that superlattice TE diffraction spots of K phase of the $L'l_2$ crystal structure are observed. The dark field image taken out of a (100) superlattice spot shows a high density of a finely dispersed coherent phase particles (~80Å in size). Selected area diffraction pattern shown that this K phase does not transform to martensite after quenching to liquid nitrogen temperature, but it maintains Bain relationship with the transformed martensite. This orientation relationship between martensite and K phase clearly indicates that Bain distortion is involved in martensite transformation. The martensite contains only (112)b type transformation twins ~100Å in width. The modulated structures and microstructural features, which reveal the absence of heterogeneous nucleation originating from grain boundaries, are observed in as-rapidly solidified specimens. Suprisingly, the modulated structures of the as-rapidly solidified specimens were coarser than that of the water-quenched ones, indicating aparent slowing-down of the cooling rate in some temperature range during cooling. These microstructural features are consistent with the early spinodal decomposition of this alloy. However, the formation of the modulated structures does not merely suggest that the supersaturated austenite can decompose spinodally. The modulated structures that were formed during the early stage of phase decomposition tend to undergo a precipitate morphology changes from the cuboid to rod shape during subsequent coarsening. This morphological change tends to be constrained by coherency strain energy of the coherent two phase mixture. When the specimens aged at 850$^\circ{C}$ are water quenched, part of austenite transforms into martensite. As the aging time increases, interparticle spacings of coarsened K phase particles increase to the extent that the martensite lattice is not distorted by K phase particles. Simultaneously, both the lattice parameter of retained austenite and the c/a ratio of martensite decreases, but the abnormal high tetragonality of martensite is still maintained. The coarsened K phase particles do not transform to martensite. In aged specimens followed by water quenching internal twins are observed in the martensite platelets. Altogether, these observations suggest that the abnormal high tetragonality of Fe-7wt.% Al-1.8wt.%C martensite is ascribed to the constraint imposed onto the Bain distortion by the atomic ordering of inhomogeneous austenite at high temperatures.