"She is drinking tea instead."
Translation:Hun drikker te i stedet.
'sted/stad' used to be a masculine noun, but 'sted' has become neuter, while the form 'stad' is still masculine (as in 'en hovedstad'). There are still some phrases where 'sted' is used as a masculine noun, such as this.
The way a word is spelled is somewhat arbitrary, but since 'isteden' can't really be split into smaller words. This is because 'steden' isn't really a word anymore, so it's written without a space. But since 'i' and 'stedet' are words, you'd write 'i stedet' with a space. The meaning is the same.
You will still see people write 'istedet' even though this is technically not correct. It's kinda like writing 'alot' in English.