"The virtual world is the next great frontier and in some respects is still very much a Wild West environment," the organisation said.
"Unfortunately, what started out as a benign environment where people would congregate to share information or explore fantasy worlds is now offering the opportunity for religious/political extremists to recruit, rehearse, transfer money and ultimately engage in information warfare or worse with impunity."
IARPA recommends setting up 'Red' teams of intelligence operatives who would investigate virtual worlds and track potential threats.
The CIA already has a presence in Second Life which it uses it for meetings and training.
However, the IARPA report has been questioned by privacy campaigners. Jim Dempsey, policy director at the Center for Democracy and Technology, pointed out that the government had said the same things about mobile phones and the internet.
"They want to control this technology and make it even easier to tap than it already is," he said.
"When the government is finished, every new technology becomes a more powerful surveillance tool than the technology before it."
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iTnews State of Security Breakfast Sydney
iTnews Executive Retreat - Security Leaders Edition - VIC
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