State broadcaster CCTV said the Xile Lier company had been mixing out-of-date formula with supplies imported under its partnership agreement with Hero.
It said the Chinese firm's "legal representative" had been held for unspecified "criminal activities".
It is the latest food safety scandal to hit China.
Baby formula is a particularly sensitive product after at least six babies died and another 300,000 became ill in 2008 from drinking milk tainted with the toxic chemical compound melamine.
Demand for imported baby milk has soared as a result, even leading to stock shortages in supermarkets abroad as Chinese buyers snap up the products in bulk and ship them back for family or re-sale.
Hong Kong last month imposed limits on travellers' formula exports to China.
CCTV said government investigators had accused Xile Lier of illegal practices including mixing imported formula with out-of-date product, changing sell-by dates on packaging, and re-labelling formula for older babies as more expensive milk for younger children.
Authorities in Suzhou in the eastern province of Jiangsu, where Xile Lier is based, told AFP they shut down production lines at the firm in November after a whistle-blower's report.
"We've handed over the case to the police," said an official surnamed Liu at the Suzhou Bureau of Quality and Technical Supervision, adding he could not provide further details.
But the products, which are sold under the Hero Nutradefence label, have remained widely available in Chinese shops.
Xile Lier's outlet on 360buy.com, a major Chinese Internet marketplace, was offline Thursday, and none of its baby milk products were available on its main store on Tmall, another e-commerce site.
No Xile Lier officials could be reached for comment.
Police in Suzhou referred inquiries to the city's party propaganda department, which referred AFP to the industrial zone where the company is based.
It said it would issue a statement "soon".
Hero, headquartered in Lenzburg in the Swiss canton of Aargau, is privately owned and has a turnover of almost $1.5 billion, according to its website.
It did not immediately respond to requests for comment on Thursday.