The 22-year-old was charged with committing a terrorist act and attempted murder after stabbing a man walking through a nature reserve "a number of times," according to a statement from the Australian Joint Counter Terrorism Team.
The victim suffered serious injuries and was hospitalized. He remains in critical condition.
The attacker allegedly attempted to stab a responding officer through a window before he was arrested. A large knife was recovered from the scene and taken for forensic analysis.
In a news conference, New South Wales Police Deputy Commissioner Catherine Burn said it was a premeditated attack that "may well have been" an attempt to lure police into an attack.
"There was clearly some degree of planning and preparation ... just before the incident happened. When the police arrived he confronted them. We will allege... that he was going to attack (the police) but fortunately that didn't happen."
She added that police were aware of the suspect's sympathies toward ISIS.
"We know that this person has strong extremists beliefs inspired by ISIS," she said.
"What made him act yesterday we don't know but hopefully further investigations will uncover that. It was deliberate, it was violent. His behavior ... it could have turned worse."
Police say the two men don't know each other, and that there is no ongoing threat to the public following the incident.
The suspect is due to appear in bail court Sunday.
Radicalization in Australia
Earlier this year, New South Wales police arrested a 16-year-old boy in Sydney on suspicion of plotting a terror attack on an Anzac Day ceremony, a similar narrative to arrests made a year ago, when five young men were arrested in Melbourne ahead of a 2015 Anzac ceremony, in what police then called a major counter terrorism operation.
In 2014, self-styled cleric Man Haron Monis held several people hostage at a Sydney coffee shop, ultimately killing two of them.
Then-Prime Minister Tony Abbott described Monis as "a deeply disturbed individual (with) a long history of crime, a long history of mental instability and infatuation with extremism," adding that he "sought to cloak his actions with the symbolism of the (ISIS) death cult."
Other Australians have been seduced by the lure of extremism, including Abdullah Elmir, a 17-year-old Australian who allegedly fled to Syria before appearing in an ISIS propaganda video vowing to raise the ISIS flag over the White House.