Villar, 67, a senior vice president of FIFA, world football's governing body, was being held on suspicion of abusing his position to embezzle funds from the federation, among other charges, the source said.
FIFA declined to comment on the arrest, with a spokesman saying it was an "internal affair" for Spain despite Villar's years as a top international football administrator.
His son Gorka along with federation vice president and financial chief Juan Padron were also held in connection with the probe which notably focuses on allegations of skimming profits from international matches, the source told AFP.
An investigating magistrate from Spain's political and financial crimes court is leading the probe into allegations of "collusion, fraud, embezzlement and presumed forgery."
Police who carried out raids on the federation headquarters and other locations related to the probe said that Villar is suspected of organising international football matches as part of a scheme to embezzle funds for the benefit of his son.
Inigo Mendez de Vigo, a spokesman for the Spanish government, told public television in response to the Villar arrest that "no-one is untouchable and everyone must obey the law."
Villar, a former acting president and current vice president of UEFA, which runs European football, has headed the Spanish federation since 1988.
He was reelected unopposed for an eighth term in May despite allegations of vote-rigging that cast a shadow over his win.
Following his re-election in May, El Pais newspaper denounced his "despotic" management and bemoaned his close ties to FIFA and UEFA leaders embroiled in corruption probes.
- Ethical questions -
His son Gorka Villar is a former director general of CONMEBOL, the South American football confederation, a post he quit in July last year. He also served on a FIFA advisory panel aimed at reforming the organisation mired in corruption allegations.
Villar senior has overseen a glorious period in the Spanish national team's history as they won three consecutive major tournaments, triumphing at Euro 2008 and 2012 either side of a first ever World Cup in South Africa in 2010.
But his critics say his period in charge has also been undermined by ethical questions and an autocratic management style.
Javier Tebas, the head of the Spanish league, has had a long-running feud with Villar and refers to him as a feudal baron.
Villar managed to survive the massive corruption scandal that engulfed FIFA in 2015 and ultimately led to the downfall of former president Sepp Blatter.
He rose to become stand-in UEFA head for almost a year from October 2015 when Michel Platini was fighting to keep his job before he was banned from football for corruption.
But the former Athletic Bilbao midfielder, capped 22 times for Spain, has been dogged by ethical issues over the years.
He was implicated in a scheme to build a football academy in Haiti funded by a public loan of 1.2 million euros ($1.4 million). The school was never built and the federation returned the money but the plan is still the subject of court proceedings.
In early 2016 the government's sports council ordered the opening of a disciplinary probe into his alleged misconduct in dealings with a third division club.
Most notably he was fined 25,000 Swiss francs ($25,700) by FIFA's ethics committee in 2015 for failing to cooperate during an investigation into the awarding of the 2018 and 2022 World Cups to Russia and Qatar respectively.