Six men and a woman, all in their twenties, were arrested in overnight raids across Melbourne, Australia's second-largest city, involving counter-terrorism police and Australia's domestic spy agency, Victoria state police said in a statement.
"This is a significant disruption of what we would describe as an imminent terrorist event in Melbourne," Australian Federal Police Commissioner Andrew Colvin told reporters in Sydney.
He said the threat had been "removed... in its entirety", however security in Melbourne was boosted on Friday.
Acting Victorian police commissioner Graham Ashton said extra police would be on patrol on Christmas Day and at the annual Boxing Day cricket test, which attracts tens of thousands of fans every year, in Melbourne the following day.
Australian Prime Minister Malcolm Turnbull told reporters that the planned attack was an "Islamist terrorist plot" and "one of the most substantial terrorist plots that have been disrupted over the last several years".
The plot targeted high-profile locations in Melbourne, including Federation Square, Flinders Street Station and St Paul's Cathedral "possibly on Christmas Day", Ashton said.
It was inspired by the Islamic State militant group and the suspects had been under close surveillance for a fortnight, he said. One of the suspected planners in custody was an Egyptian-born Australian and the others were all Australian-born of Lebanese descent, Ashton told reporters.
Two of those arrested, including the woman, were released without charge but at least four of the five men still in custody would likely face court on Friday, a police statement said.
Police are able to hold terror suspects without charge for four hours but they can also apply to a court to detain them without charge for as long as two weeks.
Few details were released about what evidence was collected by police during the raids in suburbs in Melbourne's northwest but Ashton said the attacks would likely have involved explosives and either guns or knives.
Australia, a staunch US ally which sent troops to fight in Afghanistan and Iraq, has been on heightened alert for attacks by home-grown radicals since 2014.
Authorities have said they have thwarted a number of plots, particularly involving radicalised teenagers, in recent years.
There have also been several "lone wolf" assaults, including a 2014 cafe siege in Sydney in which two hostages and a gunman were killed, and the killing of a police accountant in 2015.