Australian police say they have prevented an "imminent" terror attack linked to Islamic State (IS) after arresting two men in a Sydney suburb.

Police say a machete, a hunting knife and homemade IS flag were seized in Fairfield, as well as a video of a man talking about an attack.

New South Wales Deputy Police Commissioner Catherine Burn said the planned attack was "consistent with the messaging coming out of IS".

State premier Mike Baird said a potentially "catastrophic" incident had been avoided.

He said: "It was beyond disturbing, what was planned. Certainly, something catastrophic was avoided... and for that we should be very thankful."

When asked whether a beheading was planned, Ms Burns said police were unsure of the attack's nature, but added it was imminent and likely to have involved a knife.

"We believe that the men were potentially going to harm somebody, maybe even kill somebody, and potentially using one of the items that we identified and recovered yesterday, potentially a knife," she said.

The men, aged 24 and 25, would have carried out the attack on Tuesday if they had not been arrested that day, Ms Burns added.

"We built up information, we received further information which indicated an attack was imminent, and we acted."

Omar al Kutobi and Mohammad Kiad have been charged with undertaking acts in preparation or planning for a terrorist act, which carries a maximum punishment of life in prison.

They were refused bail during a brief court hearing on Wednesday. Neither man appeared in the courtroom.

Ms Burn said the men were not previously on their radar and she did not know whether the alleged target was the police, military or the general public.

She did confirm that one of those arrested features in the video that was seized.

Prime Minister Tony Abbott told Parliament the footage depicted one of the suspects kneeling in front of the IS flag with the knife and machete while making a statement in Arabic.

Police are trying to determine if the men were in contact with anyone associated with IS.

In December, a gunman claiming to represent IS took 18 people hostage in a 16-hour siege at a Sydney cafe. The hostage situation ended in a hail of gunfire when police rushed the cafe.

A number of raids have been carried out in Sydney and Melbourne since Australia raised its terror threat level to high for the first time in September, citing the likelihood of attacks by Australians radicalised in Iraq or Syria.