Most right-handers perceive an octave illusion when they are presented with a 400 Hz tone to one ear and with a 800 Hz tone to the other ear simultaneously, and when the tones continuously reverse between the ears: instead of the correct sound sequence, the subjects typically report a high tone in the right ear alternating with a low tone in the left. To study the neural basis of the illusion, we recorded neuromagnetic responses to binaural 400 and 800 Hz tones in different combinations. In the auditory cortex of each hemisphere, the 100 ms response (N100m) was stronger to pairs where the 800 Hz tone was presented to the contralateral ear and the 400 Hz tone to the ipsilateral ear than vice versa. The sustained fields tended to behave in an opposite manner. We suggest that the perceived locations of the sounds in the octave illusion follow the N100m lateralization, and the percept is contributed by streaming by the ear.