When the American Revolutionary War broke out, Stephen offered his services to the Continental Army, again serving under Washington. He was with the army during the New York and New Jersey campaigns of 1776 and early 1777, and as a major general he was given command of a division in Washington's army during the defense of Philadelphia. In the October 1777 Battle of Germantown, Stephen's men fought in the fog with troops led by General Anthony Wayne. Stephen was accused of being drunk during the battle, and after being convicted in a court martial, he was stripped of his command and cashiered out of the army, making him the only Continental Army general court-martialed and immediately dismissed from the service during the war.

When the war ended, he returned to Berkeley County. In 1778 Stephen laid out the plan for Martinsburg and named the town after his friend, Colonel Thomas Bryan Martin. Stephen became sheriff of Berkeley County, with Martinsburg as the county seat. Generals Horatio Gates and Charles Lee both purchased property in the county and lived nearby. In 1780, Berkeley County voters elected Stephen as one of their (part-time) representatives in the Virginia House of Delegates. In 1788, he was elected to the Virginia Ratifying Convention, where he spoke (and voted) in favor of ratification of the Constitution of the United States.