The Sydney man is alleged to have repeatedly stabbed a stranger in the street in a ferocious assault yesterday.
The 22-year-old is believed to have knifed the 59-year-old, who was walking peacefully through a park, until police arrived.
He then made statements which they said led them to conclude he was motivated by ISIS.
New South Wales Police Deputy Commissioner Catherine Burn said: “We know this person has strong extremist beliefs inspired by ISIS.”
She added the victim was in a critical but stable condition.
Australia, a staunch US ally, has been on heightened alert for attacks by home-grown radicals since 2014.
Since then, authorities have said they have thwarted a number of plots.
There have been several “lone wolf” assaults, however, including a 2014 cafe siege in Sydney that left two hostages and the gunman dead.