This paper discusses observability of the vehicle states using different sensor configurations as well as fault-tolerant estimation of these states. The optimality of the sensor configurations is assessed through different observability measures and by using a 3-DOF linear vehicle model that incorporates yaw, roll and lateral motions of the vehicle. The most optimal sensor configuration is adopted and an observer is designed to estimate the states of the vehicle handling dynamics. Robustness of the observer against sensor failure is investigated. A fault-tolerant adaptive estimation algorithm is developed to mitigate any possible faults arising from the sensor failures. Effectiveness of the proposed fault-tolerant estimation scheme is demonstrated through numerical analysis and CarSim simulation.