Two men had been arrested in Cibinong, in West Java, and led police to a house nearby, at the Jatiluhur dam, national police spokesman Awi Setiyono said. "There were two men there and there was a gunfight and we had to shoot them," said Setiyono.
Police seized some weapons and a letter which said the group had planned to launch an attack at an undisclosed location on new year's eve, West Java police spokesman Yusri Yunus told Metro TV.
A police bomb squad was still scanning the area for any explosives, Yunus added.
According to Reuters, earlier this week, Indonesian anti-terrorism police killed three suspects in a gun battle on the outskirts of the capital Jakarta, and said they had foiled a suicide bombing planned for the end of the year.
Police have arrested dozens of suspected militants in recent months, including a cell on Batam island that planned a rocket attack on neighboring Singapore.
Indonesia has foiled at least 14 attacks this year alone and made more than 150 arrests.
A gun and bomb assault in the heart of Jakarta in January 2016 killed four people and was the first attack in Southeast Asia claimed by Islamic State jihadists.
Indonesia will to deploy 85,000 police and 15,000 military personnel for the Christmas and New Year period, police said.