By Phil Mercer
BBC News, Sydney
Dragan Vasiljkovic, who has dual Serbian and Australian nationality, was taken into custody in Sydney.
A court in Croatia recently issued a warrant for his arrest, but he has denied committing war crimes.
Croatian authorities have accused him of ordering the torture and murder of soldiers and civilians during the Serbo-Croat war in the early 1990s.
Croat officials claim Dragan Vasiljkovic was a commander of a Serb paramilitary unit that committed atrocities during the break-up of Yugoslavia.
It is alleged he was sent to Croatia to help train Serb rebels.
The 51-year-old suspect, known as Captain Dragan, returned to Australia after the conflict ended.
He has been living in Perth and working as a golf instructor.
The Croatian government now has 60 days to formally apply for his extradition.
Once a request has been made, the case will be heard by a federal judge.
Any decision would have to be approved by the Australian government.
Mr Vasiljikovic has testified at the war crimes trial of former Yugoslav President Slobodan Milosevic at the UN tribunal in The Hague.