Federal agents and Victoria police arrested seven people for allegedly plotting to set off bombs around key targets in central Melbourne, possibly on Christmas Day itself.  Two have since been released.

"This is one of the most substantial terrorist plots that have been disrupted over the last several years," said Prime Minister Malcolm Turnbull.

The investigation is called "Operation Kastelholm".  Victoria and Federal Police, along with the Australian Security Intelligence Organization (ASIO), raided locations in Flemington, Meadow Heights, and Dallas in Melbourne's north on Thursday night and Friday morning. 

"What they have uncovered is a plot to explode improvised explosive devices in central Melbourne in the area of Federation Square, on or about Christmas Day," said the PM.  Flinders Station and St. Paul Cathedral were also said to be targets.

Victoria state Police Chief Commissioner Graham Ashton said the "potential for quite a number of people to be injured or killed in this attack", which he added was inspired by the terrorists of the so-called Islamic State.

Of the seven people arrested, a 26-year-old man and 20-year-old woman from Meadow Heights were released without being charged.  The other five are men from the Melbourne area; one of them was born in Egypt and the others had Lebanese backgrounds.