BACKGROUND: The sparse connectivity of protein-protein interaction data sets makes identification of functional modules challenging. The purpose of this study is to critically evaluate a novel clustering technique for clustering and detecting functional modules in protein-protein interaction networks, termed STM. RESULTS: STM selects representative proteins for each cluster and iteratively refines clusters based on a combination of the signal transduced and graph topology. STM is found to be effective at detecting clusters with a diverse range of interaction structures that are significant on measures of biological relevance. The STM approach is compared to six competing approaches including the maximum clique, quasi-clique, minimum cut, betweeness cut and Markov Clustering (MCL) algorithms. The clusters obtained by each technique are compared for enrichment of biological function. STM generates larger clusters and the clusters identified have p-values that are approximately 125-fold better than the other methods on biological function. An important strength of STM is that the percentage of proteins that are discarded to create clusters is much lower than the other approaches. CONCLUSION: STM outperforms competing approaches and is capable of effectively detecting both densely and sparsely connected, biologically relevant functional modules with fewer discards.