Altaf Hussain, who is wanted at home in relation to a murder case, has lived in London in self-imposed exile since the early 1990s.
Known for his fiery addresses to his supporters in Karachi though a loudspeaker connected to a telephone, Mr Hussain effectively controls the violent port city of Karachi from his headquarters in a north London suburb.
British police said that a 60-year-old man had been arrested on suspicion of money-laundering during an early morning raid on a house in northwest London but declined to confirm his identity.
Special operations officers were searching the property.
A spokesman for his powerful Muttahida Qaumi Movement (MQM) party in north London confirmed Mr Hussain had been arrested but no further details were immediately available.
Supporters praise him as a business-oriented leader of Pakistan's educated middle class, but opponents describe him as a tyrant and accuse him of murder and violence.
The MQM party's support base is millions of Muslim Urdu-speaking people whose families migrated to Karachi and nearby areas at the time of the 1947 partition.
Mr Hussain's hold on Karachi is so strong he is capable of shutting down entire neighbourhoods of the city of 18 million.
Within minutes of his arrest, shopkeepers and market stall owners closed their businesses for fear of violence, residents said.
Deputy Inspector General Abdul Khalique Shaikh said: "We deployed extra security at the British High Commission in the southern part of Karachi as soon as we learnt about Altaf Hussain's arrest in London.
"We have increased police patrolling and we are making further deployments at sensitive spots in the city."
Tension was high and residents said the city came to a standstill due to massive traffic jams as people rushed home for fear of violence.