The image was posted on the Twitter account of Khaled Sharrouf, The Australian newspaper reported.
Sharrouf, who served time for planning attacks in Australia, has now joined Islamic State (IS) militants in Syria.
Mr Abbott said the image showed "just how barbaric" IS militants were.
The image shows a young boy - who looks to be of early primary school age - wearing a baseball cap and a blue shirt, using both hands to hold aloft the severed head.
A caption was included that read "That's my boy", The Australian said. It said the image was taken in the northern Syrian city of Raqa.
Another picture showed Sharrouf wearing combat fatigues posing with three children believed by security personnel to be his sons, the newspaper reported.
"What we've got to appreciate is that Islamic State... is not just a terrorist group, it's a terrorist army and they're seeking not just a terrorist enclave but effectively a terrorist state," Mr Abbott told Australian radio from the Netherlands, where he is discussing issues related to flight MH17, the passenger plane brought down in Ukraine.
"And this does pose extraordinary problems... not just for the people of the Middle East but for the wider world.
"And we see more and more evidence of just how barbaric this particular entity is."
Sharrouf was jailed in 2009 for four years for being part of a cell planning attacks in Sydney and Melbourne.
After his release he was banned from leaving the country but used his brother's passport to travel to Syria with his family.
Australia issued a warrant for his arrest in July after images emerged on what is thought to be his Twitter feed of another Australian, Mohamed Elomar, holding the severed heads of Syrian government soldiers.
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