Nanocrystalline materials reveal excellent mechanical properties but the mechanism by which they deform is still debated. X-ray line broadening indicates the presence of large heterogeneous strains even when the average grain size is smaller than 10 nm. Although the primary sources of heterogeneous strains are dislocations their direct observation in nanocrystalline materials is challenging. In order to identify the source of heterogeneous strains in nanocrystalline materials we prepared Pd-10%Au specimens by inert gas condensation and applied high pressure torsion (HPT) up to γ≅21. High resolution transmission electron microscopy (HRTEM) and molecular dynamic (MD) simulations are used to investigate the dislocation structure in the grain-interiors and in the grain boundary (GB) regions in the as-prepared and HPT deformed specimens. Our results show that most of the GBs contain lattice dislocations with high densities. The average dislocation densities determined by HRTEM and MD simulation are in good correlation with the values provided by X-ray line profile analysis. Strain distribution determined by MD simulation is shown to follow the Krivoglaz-Wilkens strain function of dislocations. Experiments, MD simulations and theoretical analysis all prove that the sources of strain broadening in X-ray diffraction of nanocrystalline materials are lattice dislocations in the GB-region. The results are discussed in terms of misfit dislocations emanating in the GB-regions reducing elastic strain compatibility. The results provide fundamental new insight for understanding the role of GBs in plastic deformation in both nanograin and coarse grain materials of any grain size.