Dotcom, a dual citizen of Germany and Finland who changed his name from Schmitz, was detained on charges of copyright infringement conspiracy, according to Bloomberg.
Police also arrested a Dutch citizen who lives in New Zealand and two German nationals.
The case will be the first time extradition on copyright offenses has been tested in any international court, according to New Zealand legal experts.
Dotcom is wanted in the US on charges that his file-sharing website, which enabled the exchange of pirated films and music, is part of a $175m five-year copyright infringement conspiracy.
Megaupload’s founder was charged in the US because some of the site’s servers were based in Virginia and Washington, according to the Justice Department.
If found guilty, Dotcom faces up to 20 years in prison.
Before being shut down by US law enforcement over the weekend, Megaupload.com claimed to have more than one billion visitors, more than 150 million users, 50 million daily visitors, and accounted for 4% of internet traffic, according to prosecutors.
In accordance with the extradition treaty between the US and New Zealand, the US has 45 days from the date of the arrest to make a formal extradition request.
But for the extradition to go ahead, New Zealand prosecutors must show Dotcom is accused of an offense that would be punishable by at least 12 months in jail in both the US and New Zealand.
Dotcom was detained in a New Zealand jail, pending a ruling on his bail application.
A group claiming to be Anonymous said it will replace Megaupload, but a post on an Anonymous Twitter feed warned that the Anonyupload website may be a scam and claimed the hacking group has "no affiliation" with it, according to New Zealand reports.
This story was first published by Computer Weekly