Sludge in Transformer is formed as the oil breaks down. Sludge attacks the cellulose of the transformer windings causing it to deteriorate. It reduces the oil circulation inside the transformer. 
Sludge also forms a layer on the transformer winding and reduces the heat transfer. These lead to higher transformer winding temperatures.
Sludge thus has to be removed. The transformer oil can be replaced or filtered.
See Also: Transformer oil Deterioration