Customs Minister Chris Ellison said the prison ship would significantly increase Australia's ability to fight illegal fishing because it meant patrol boats that apprehend trawlers at sea no longer had return to the mainland to deposit captives.
"The vessel will have the capability to remain at sea for extended periods and operate independently in waters around Australia," Ellison said.
"It will also be able to act as a command ship during operations."
Illegal fishing has increased dramatically in Australia's northern waters as Indonesian marine stocks are fished out and demand for shark fin booms among wealthy Chinese.
A two-week operation earlier this year resulted in the apprehension of 23 fishing boats and 197 crew.
At one point, Australia proposed joint patrols with the Indonesian navy but the plan was shelved after a dispute over Canberra's decision to grant asylum to dissidents from Indonesia's restive Papua province.
Mr Ellison's office said the prison ship could also be used to detain asylum seekers caught trying to reach Australia.
Mr Ellison said Australia was planning to tender for a private vessel with a civilian crew that would carry up to 30 armed Customs officers and have the capacity to hold up to 30 illegal fishermen for up to a month.
It will be armed with two deck-mounted .50 calibre machineguns, similar to a civilian vessel "Oceanic Viking" that Canberra began chartering in 2004 to help stop illegal fishing in its southern waters near Antarctica.
The government is tendering for a suitable ship to be converted into a floating prison and hopes to have it operating by next January.
'Cruel plan': Labor
The Labor Party opposition branded the plan cruel and said establishing a specialised coast guard was the best way to tackle illegal fishing.
"It seems to be a patchwork solution to what seems to be a very serious problem of illegal fishers entering our northern waters," opposition customs spokesman Joe Ludwig said.
"What you are going to have is illegal fishers being held in detention on a boat out at sea for 30 days in the ship's brig. It seems a little bit cruel to me, quite frankly."
Prime Minister John Howard defended the plan, which will cost an estimated 10 million dollars a year.
"The need for it is obvious," Mr Howard said. "This is a particular need in a special situation, I think it's highly appropriate."