Victoria and Australian Federal police made the classification on Monday after the Adass Israel Synagogue attack in Melbourne's southeast on Friday.
The investigation will now transition to the Joint Counter Terrorism Team.
"This is likely to be a politically motivated attack. This is now a terrorism investigation," AFP Deputy Commissioner for National Security, Krissy Barrett told reporters.
Police are looking for three suspects.
Victorian Chief Commissioner Shane Patton defended not making the declaration sooner.
"Based on the assessment at the time of having a crime scene, albeit in a circumstance and on a synagogue, it was not believed to be sufficient to establish the threshold for a terrorist attack to be declared," he said.
"We've investigated over the weekend, we've had significant progress."
The firebombing of a synagogue was likely a terrorist incident, police say. (Con Chronis/AAP PHOTOS)
The declaration opens up a raft of extra powers for investigators including the ability to stop, search and seize people without a warrant as well as detain and question those they believe have knowledge of, or links to, the attack.Â
The Victorian Joint Counter Terrorism Team is made up of state and federal police, and ASIO officers.
Two of the synagogue's three buildings were gutted in the fire that erupted in the early hours of Friday.
Two people who were inside at the time preparing for morning prayers escaped, with one suffering minor injuries.
"We have ensured that we have increased police in the areas, increased visibility, and making sure that we're out and about at synagogues, at other places of worship, at places of significance to the Jewish community," Mr Patton told reporters.
Jewish community leaders have vowed to rebuild the Adass Israel synagogue, after a firebombing. (Yumi Rosenbaum/AAP PHOTOS)
Speaking alongside Mr Patton and Ms Barrett, Premier Jacinta Allan said the government was seeking advice on how laws could be strengthened to protect people going to places of worship.
"I'm seeking initial advice on how we can strengthen the laws around making sure that people going to church, going to synagogues, going to mosques can do so safely," she said.
The government will look at strengthening laws to protect people going to places of worship. (Con Chronis/AAP PHOTOS)
"There are a range of options that are available to us - one example that I can point to is the arrangements we've had in Victoria for some time now around making sure that women accessing termination services are provided - they're able to get that health treatment and that health support free from being heckled and protested."
Jewish Community Council of Victoria CEO Naomi Levin said she had been told five Torah scrolls, handwritten copies of the book of Moses used during prayers, won't be salvaged.
Police are also investigating reports of a bullet found on a footpath near the synagogue in Glen Eira Road on Saturday afternoon.
The synagogue remains closed to the public.
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