The arrest was part of an investigation into the alleged unauthorised purchase of two Israeli generators while he was in power, Royal Papua New Guinea Constabulary assistant commissioner Hodges Ette said in a statement.
"There is reasonable evidence for misappropriation, abuse of office and official corruption," Ette said.
O'Neill was still being interviewed by police but would be granted bail to undergo two weeks of quarantine at his home, Ette said on Saturday night.
In the past, O'Neill has denied similar charges, labelling them politically motivated.
The politician's long tenure ended in 2019 and was marked by a string of corruption allegations, including the purchase of 40 Maseratis for an Asia-Pacific leaders' summit he hosted -- in a country where few homes have reliable electricity.
He was forced to step down after allies baulked at his decision to sign a multibillion-dollar liquefied natural gas deal with France's Total and US firm ExxonMobil.
Local communities had complained bitterly about not benefiting from similar deals in the past.
After promising to resign and then trying to cling to power via the courts, he was ultimately replaced by his former finance minister James Marape, who vowed to clean up the government.