The long-term reliability of power transformers is critically dependent on the chemical and mechanical integrity of their lignocellulose-based insulation systems. Despite decades of research, the complex physicochemical mechanisms governing cellulose degradation under thermal, oxidative, hydrolytic, and mechanical stresses remain only partially understood at the molecular level. This review consolidates the current understanding of cellulose degradation in transformer insulation, emphasizing the chemical pathways that drive depolymerization and the formation of key degradation products. Analytical and diagnostic techniques, including direct polymer characterization and indirect oil-based monitoring methods, are evaluated in terms of sensitivity, applicability, and limitations. Recent developments in advanced spectroscopic and scattering methods are discussed as tools for elucidating degradation at the molecular scale. The review also highlights mitigation strategies such as thermally upgraded papers, nanoparticle-enhanced composites, and antioxidant additives. Finally, emerging research directions are proposed, focusing on real-time, non-invasive monitoring, integration of multi-sensor diagnostics with AI, and interdisciplinary approaches to design more durable insulation systems.