An image processing system, and a method of operation thereof, including: a capture device for obtaining an input image block; and an image signal processing hardware coupled to the capture device, the image signal processing hardware including: a coding module including: a scaling correction module for generating a scaled wavelet block based on the input image block, a grey block detection module for determining the input image block to be a grey image block, a compression ratio module for determining the compression ratio of the input image block, a mode setting module for setting a PCM mode identifier based on the compression ratio, the coding module for generating a compressed image block by scanning and coding the input image block using PCM mode; and a decoding module for generating an output image block by decoding the compressed image block for display on a display device.