Attorney-General Philip Ruddock confirmed that Dragan Vasiljkovic, also known as 'Captain Dragan', was detained in Sydney after the Croatian government request his arrest.
Zagreb suspects Mr Vasiljkovic of being responsible for the torture and killing of Croatian civilians and prisoners of war in the rebel Serb stronghold of Knin in 1991 as well as in the southern village of Bruska in 1993.
Croatia now has 60 days to make a formal extradition request to Australia, and Mr Vasiljkovic would then appear before a magistrate who would determine whether he was able to be extradited.
"The Australian government will work closely with the Croatian government to ensure that any extradition request satisfies the requirements of the Australian Extradition Act so that proceedings can be commenced," said Mr Ruddock in a statement.
Mr Vasiljkovic, 51, has been living in Perth since December 2004 where he as been working as a golf instructor.
He was detained late on Thursday and charged with war crimes offences, police said.
"Those offences were two war crimes against prisoners of war under article 122 of the basic criminal code of Croatia and one war crime against civil population under article 120 paragraphs 1 and 2 of the basic criminal code of Croatia," a police spokesman told AFP.
Mr Vasiljkovic holds both Australian and Serbian-Montenegrin passports.
He left Australia during the Croatian and Bosnian wars of the early 1990s to command Serb paramilitaries.
He has told an Australian newspaper that he commanded a paramilitary unit during the Balkans conflict when he was known as 'Captain Dragan'.
The former Australian army reservist also said he had trained Serbian recruits, interrogated enemy soldiers, killed in combat and led attacks on command posts.
But he denied committing war crimes.
Any extradition would have to be approved by the Australian minister for justice and customs, Ruddock said.
"Australia is committed to international legal cooperation. However, we also have to ensure that persons subject to extradition requests are accorded due process under the Extradition Act," Ruddock said in a statement.
Vasiljkovic appeared in a Sydney court early Friday where he was remanded in custody until January 27 when he will reappear, police said.