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Australia's consumer watchdog is suing the country's two biggest supermarket chains, alleging they falsely claimed to have permanently dropped the prices of hundreds of items.

The Australian Competition and Consumer Commission (ACCC) claims Coles and Woolworths broke consumer law by temporarily raising prices before lowering them to a value either the same as or higher than the original cost.

Coles said it would defend itself against the allegations, while Woolworths said it would review the claims.

The grocery giants, which account for two thirds of the Australian market, have come under increasing scrutiny in the past year over alleged price gouging and anti-competitive practices.

Prime Minister Anthony Albanese said the alleged conduct, if proven to be true, is "completely unacceptable".

"This is not in the Australian spirit. Customers don't deserve to be treated as fools," he said at a press conference, at which he also revealed draft legislation for a previously promised "code of conduct" for supermarkets.

ACCC chair Gina Cass-Gottlieb said Coles and Woolworths have spent years marketing their 'Prices Dropped' and 'Down Down' promotions, which Australian shoppers now understand to represent a sustained reduction in the regular prices of products.

But in many cases "the discounts were, in fact, illusory", she added.

The watchdog's investigation - sparked by complaints and the ACCC's own monitoring - found Woolworths had misled customers about 266 products over 20 months, and Coles for 245 products across 15 months.

The products included everything from pet food, Band-Aid plasters and mouthwash, to Australian favourites like Arnott's Tim Tam biscuits, Bega Cheese and Kellogg's cereal.

The ACCC estimated that the two companies “sold tens of millions" of the affected products and "derived significant revenue from those sales".

“Many consumers rely on discounts to help their grocery budgets stretch further, particularly during this time of cost of living pressures,” Ms Cass-Gottlieb said.

"It is critical that Australian consumers are able to rely on the accuracy of pricing and discount claims."

The ACCC is seeking that the Federal Court of Australia impose "significant" penalties on the two firms, and an order forcing them to increase their charitable meal delivery programs.

In a statement, Coles said the company's own costs were rising which led to an increase in product prices.

It had "sought to strike an appropriate balance" between managing that and "offering value to customers" by restarting promotions "as soon as possible" after new prices were set, it said.

The company takes consumer law "extremely seriously" and "places great emphasis on building trust with all stakeholders", it added.

Woolworths said in a statement that it would engage with the ACCC over the claims.

"Our customers are telling us they want us to work even harder to deliver meaningful value to them and it's important they can trust the value they see when shopping our stores."

Amid growing scrutiny of the supermarkets, the government commissioned a review of the country's existing Food and Grocery Code of Conduct.

The review recommended a stronger, mandatory code of conduct be introduced and policed by the ACCC, so they can protect suppliers as well as consumers.

The new code will set out standards for the companies' dealings with providers, who say they are being unfairly squeezed, and introduce massive fines for breaches.