"A substantial attack" using explosives and other weapons was planned for Melbourne's Flinders Street Station, Federation Square and St Paul's Cathedral on Christmas Day.
Heavily armed police raided homes across Melbourne's north on Friday morning and arrested seven people, with five accused still in custody to face court in the afternoon.
Chief Commissioner Graham Ashton said those arrested planned to attack the iconic train station, Federation Square and St Paul's Cathedral on Christmas Day.
"We believe (they are) self-radicalised. They are inspired by ISIS and ISIS propaganda," Mr Ashton told reporters.
Prime Minister Malcolm Turnbull condemned the terror plot.
"We congregate in public places for Christmas, for New Year's Eve. It is a time of happiness and joy. These terrorists sought to disrupt it. They have been thwarted," he said.
Police found evidence of an explosive device in their raids across properties in Flemington, Dallas, Gladstone Park, Meadow Heights and Campbellfield.
Mr Ashton said the plot included "a multi-mode attack" including an explosion and an attack with weapons.
"We believe it was certainly going to involve an explosive event," Mr Ashton said.
"We gathered the makings of an improvised explosive device."
"A substantial number of people could have been injured in the attack, from what we've seen.
"Certainly (there was) potential for quite a number of people to be injured or killed in this attack."
About 400 police officers were involved in the raids, which started late on Thursday night.
"In relation to this particular plot we think we've got everyone who was involved," Mr Ashton said.
Five people in their 20s are due to face court - four are Australian-born, while the fifth is an Egyptian-born Australian citizen.
Authorities have been on global alert after a truck was driven into a Christmas market in Germany, and Mr Ashton said police did not know yet how the explosive device would have been delivered.
Premier Daniel Andrews said there will be extra police on the streets on Christmas Day to ensure the public feel safe.
"What was being planned was not an act of faith, was not an act of religious observance, it was instead in its planning, an act of evil, a criminal act," he said.
Federal opposition leader Bill Shorten said people should go about their Christmas as usual.
"Australians should be confident that our security agencies, our police, and our Defence forces are among the best in the world and they are doing a great job," Mr Shorten told reporters.
