British and French media said Williams - a Rugby World Cup winner - was arrested with former Wallabies star James O'Connor.
The pair were reportedly arrested outside a nightclub near the Arc de Triomphe, in central Paris. Williams is based there after coming out of retirement to play for Racing 92 this season.
A report in LCI.fr alleged the pair were detained after buying cocaine.
The two rugby stars were reportedly taken into custody.
The media outlet reported Williams and O'Connor were both intoxicated at the time of their arrest.
LCI.fr reported that Williams allegedly tried to throw away several packets containing cocaine after being approached by plain clothes police officers.
The Daily Telegraph reported a police source as saying the two were apprehended by officers of the French Anti-Crime Brigade at 3am (3pm Saturday, NZT) in the Paris 16th district and placed in police custody.
They were expected to be held in custody for up to 24 hours, the source added.
A judicial source told the Telegraph that the players are accused of attempting to buy drugs worth about €200 euros ($NZ290) and that the two suspected sellers had also been arrested.
Racing 92 released a statement on Saturday confirming Williams would not be considered for selection until the matter was resolved.
"A player of Racing 92 is at the heart of an investigation into the possession of cocaine," the statement read.
"It was decided to temporarily suspend Ali Williams. If the investigation confirmed the possession of cocaine and the transaction, it would not only be against the law but also a serious breach of our ethics.
"We want to assure our partners, and our supporters of our total determination to uphold our values, and we apologise to all club and sport lovers for the disorder caused, and thank them for their loyalty."
The arrests come only days after former All Black Dan Carter was forced to apologise for "a massive error of judgment" after he allegedly failed a drink-driving test in France.
Carter also plays for Racing 92, the defending French champions.
Over the course of his career Williams picked up 77 caps for the All Blacks, including an appearance as a replacement in the home 2011 World Cup final win over France.
The 35-year-old has not been immune to controversy in the past. In 2007 whilst in South Africa with club side Blues he was sent home for 'disciplinary problems', including late night drinking sessions and a lack of respect for team management.
Commenting shortly after the incident, Williams took a measure of responsibility for his actions but added: 'It takes two to tango.'
O'Connor has not played for Australia since 2013 when he was stood down by the ARU following a drunken row that saw him escorted out of Perth airport.
Hours after Australia's Rugby Championship win over Argentina in September 2013 O'Connor was refused entry to a flight to Bali with his girlfriend after engaging in a row with airline staff. The Australian Federal Police later confirmed they had removed O'Connor from the airport.
Shortly after that incident the talented back moved to London Irish. O'Connor returned to Super Rugby in 2015 with Reds but moved back to Europe to join Toulon, where he has been a regular this season.