Giuseppe Serafino, 48, who has lived and worked in Bali for the last five years, and former British journalist David Matthew Fox, 54, have been taken into custody after allegedly being found with 17 grams of hashish between them.
Police said the Australian had 7 grams of the drug in a black travel bag at his home in Sanur, in Bali's south-east.
Denpasar Police Chief Hadi Purnomo, who is also the head of the anti-drug unit, said Serafino alleged he had received the drugs from the British man.
Matthew was arrested at a bar in Sanur and was allegedly found in possession of 10 grams of hashish, some of which was found hidden in a boxing glove at another house.
The men are expected to be interrogated by police today. If found guilty, they face between five years and life in prison.
The Department of Foreign Affairs and Trade (DFAT) said it was aware of the arrest.
"Our Consulate-General in Bali is making arrangements to visit the man and stands ready to provide consular assistance," a spokesperson said.