One of two men at the centre of an alleged Sydney terrorist plot recorded a video in front of an Islamic State flag just 20 minutes before heavily armed officers stormed the pair's makeshift home, police say.

Omar Al-Kutobi, 24, a student who fled war-torn Iraq for Australia, and Mohammad Kiad, 25, a nurse who moved from Kuwait in 2012, are accused of plotting an imminent terrorist act.

The men were arrested during a raid on a converted garage in the backyard of a house in Fairfield on Tuesday.

Mohammad Kiad was allegedly planning to kill someone in an attack inspired by Islamic State. ( Supplied: Facebook )

Police say a machete, hunting knife and home-made Islamic State flag were found in the home.

Kutobi and Kiad have been charged with undertaking acts in preparation or planning for a terrorist act.

Their case was due to be heard in Fairfield Local Court on Wednesday but was adjourned to Sydney's Central Local Court because of security issues and the nature of the charges.

They will appear via video link on Thursday.

Police received a tip-off that the men were planning an attack on Tuesday morning.

They placed them under urgent surveillance, tracking them through Sydney before making their move.

They say at 3:00pm local time, the men bought a hunting knife from a military supplies shop.

It was then the counter-terrorism team decided to intervene and raid the Fairfield property.

"The type of act that we will allege that was going to be undertaken is consistent with the messaging coming out of IS," NSW Deputy Police Commissioner Catherine Burn said.

"We believe that the men were potentially going to harm somebody, maybe even kill somebody, and potentially using one of the items that we identified and recovered yesterday, potentially a knife.

Sorry, this video has expired Police hold press conference over terror arrests

"When we did the search of the premises, a number of items were located, including a machete, a hunting knife, a home-made flag representing the proscribed terrorist organisation IS, and also a video which depicted a man talking about carrying out an attack.

"I would like to however reassure the community that we are of the view that there is no further imminent attack relating to these two men."

She said the video allegedly seized in the raid was what made police believe the attack was imminent.

"One of the items that will be introduced into evidence is a video, and in that video, we will allege that one of the men indicated that an attack was going to be carried out," she said.

"We will allege that both of these men were preparing to do this act yesterday.

"We can't go into the details of what was actually said in that message. However, the intent is clear and the intent is what I have told you today."

Prime Minister Tony Abbott told Parliament on Wednesday that "police found a large ISIL or Daesh (Islamic State) flag, a machete, and a hunting knife, and a video recording of one suspect kneeling in front of the ISIL flag with the two knives whilst making a statement in Arabic."

Mr Abbott said the arrests were evidence the approach of authorities was working.

"This is a serious issue and I suspect it will get worse before it gets better... there are those out there, some living in our midst who would do us harm."

Baird labels alleged plot 'beyond disturbing'

NSW Premier Mike Baird thanked counter-terrorism police, describing the alleged plot as "beyond disturbing". He also said people should remain vigilant.

"If you see anything suspicious ring it in, because ultimately together we have the capacity to defeat this," he said.

"While our forces continue to do a first-class job, all of us have a role to play in this and I think that's what I want to continue to see.

"Certainly something catastrophic was avoided yesterday and for that we should be very thankful."

Neighbour describes moments armed police made their move

Sources close to Kiad's family told 7.30 he was not religious when he moved to Australia, but had recently become devout.

He moved in with Kutobi last year after his marriage broke down, they said.

A neighbour of the two accused men said he had no suspicion they may have been doing anything wrong.

Police raided the converted garage behind this house at Fairfield in Sydney's west. ( AAP: Ava Benny-Morrison )

Roberto Macatangay lives in a caravan at the rear of the property where the raids were carried out, and said Kutobi had lived in the converted garage there for years, while Kiad arrived more recently.

"I was sitting and watching a movie and I was in the middle of the movie and suddenly the electricity went off," he told 7.30.

"When I go out I just saw two police, I don't know if they are policemen. They are wearing black. You can't see their eyes, with their helmet, and then one of the guys says, 'Down'.

Mr Macatangay said the officer pointed a "machine gun" at him during the raid.

"I was totally scared," he added.

Mr Macatangay said he had assumed the two accused men were brothers.

"I'm really surprised that thing happened, you know, because they're harmless. I don't see anything about what's wrong with these people," he said.

"I've been in trouble but not this kind of trouble. I'm really scared of what happened."

The arrests were made by the Joint Counter Terrorism Taskforce, which has been investigating Australians suspected of plotting terrorism attacks on home soil, or Australians with links to overseas terrorists.

The taskforce has arrested about a dozen people, including 22-year-old Omarjan Azari who has been accused of plotting a campaign of random beheadings of members of the public in Sydney and Brisbane.

Azari remains in jail.