The NSW state government had planned to sell a 50.4% stake in a 99-year lease of Ausgrid to one of two Chinese bidders.
However, Australian treasurer Scott Morrison said he had told both bidders that in his "preliminary view" their proposals are "contrary to the national interest, in accordance with the required provision on the grounds of national security".
The national security concerns were principally around the power and communications services that Ausgrid provides to business and government, Morrison said.
"I am, of course, open to consider what the bidders put to me, but at this stage no suitable mitigations have been identified that would, for the proposed transaction structure, appropriately address the identified risks," he said.
Australia "will continue to welcome foreign investment that is not deemed contrary to our national interest", Morrison said.
The bidders have been asked to make further submissions by 18 August, after which Morrison will make a final decision, he said.
The Ausgrid bidders are Chinese government-owned State Grid Corporation and Hong Kong-based Cheung Kong Infrastructure, and the deal was expected to be worth around AU$10 billion (£6 billion), according to the Sydney Morning Herald.
International finance expert Margaret Cole of Pinsent Masons, the law firm behind Out-Law.com said: "The treasurer’s announcement has inevitably generated debate and is a reminder for foreign investors that proposed investments in Australia will be scrutinised and approval cannot be assumed, however attractive the commercial terms may be."