Assuming this is a 1 or 2 family dwelling, the inspector is correct. Read all about it in Appendix J- p. 598 in the MRC (Michigan Residential Code). The specific AJ301.4 Exception 3 applies. This has been in the MRC (A version of the IRC) for at least three code cycles. I have submitted a proposal to the code change committee for the 2009 MRC which should be adopted this year, that makes the wording in the MRC the same as the wording in the NEC. The proposal was accepted and when the 2009 MRC is adopted the rules for replacement receptacles will be the same in both the NEC and the MRC. Most inspectors will accept an ungrounded receptacle when it is protected upstream with a GFCI device. I suspect that the majority of inspectors don't even know about the Appendix J requirements.
