Season 2 - Episode 4 "Momentum Deferred"

When the shape shifters from a few episodes earlier return and begin to steal cryogenically frozen heads, Fringe is called in to investigate. By doing so they learn that the shape shifters are not entirely human, but are in fact a combination of machine and organic tissue, and have the need to consume mercury to stay alive. To determine who the shape shifters are, Walter brings in a woman from his past who can see who is and isn't from this universe. However, her powers are degrading and she is no longer able to use them. Also, Olivia remebers everything from her encouter with William Bell, and knows what the shape shifters are looking for and where to find it. The man impersonating Charlie tricks Olivia into revealing this information, and while he and Olivia fight, the other shape shifters regain the head of their leader. In the end the Charlie shape shifter dies, which leaves Olivia distraught over the loss of her friend, and with the shape shifters having claimed their prize, it is only a matter of time....

And where it the Observer? He is kind of difficult to find at first, but it really shouldn't take you more than 2 tries. When Olivia is caled out of the Massive Dynamic building by the shape shifter impersonating Charlie, he is watching from the other side of the road. He is quite close to the camera so he is a little blurry, but you can see that it is him. The picture is below with him in a red box, even though he takes up half the screen.