Lord Levy was released shortly after and has not been charged with any offence.
The "cash-for-favours" controversy which erupted earlier this year has dented Mr Blair's standing in opinion polls and sparked media calls for his resignation.
"Officers from the specialist crime directorate requested a man to attend a London police station this morning where he was arrested in connection with alleged offences under the Honours (Prevention of Abuses) Act 1925 and Political Parties, Elections and Referendum Act 2000," a police spokesman said.
Labour has come under pressure after officials revealed it had received nearly A$34.4 million in loans from 12 businessmen, some of whom were nominated for peerages in Britain's House of Lords after lending money.
Police have been investigating all political parties in Britain after the row broke out in March. Labour denies the allegations.
Asked about the reported arrest of Lord Levy, Mr Blair's official spokesman said: "This is a party matter and I am not going to comment on it ... I don't believe that the police have yet officially confirmed anything so I think it would be wrong for me to comment."
A 1925 law made selling seats in the House of Lords illegal.
In March, police arrested former government adviser Des Smith, who had resigned after telling an undercover reporter that anyone making donations to Mr Blair's flagship schools program could expect to receive state awards. He was released on bail.