The Counter Terrorist Unit (CTU) in North West England revealed they found the film during a raid in Manchester.
Officers say it shows two children, aged about three and six, playing with a pistol and a Kalashnikov rifle.
Material seized separately included the advice: "No child is ever too young to be started off on Jihad training."
'I want to kill'
Police believe the firearms are real.
The video shows a girl and young boy playing with guns and a man's voice says: "What do you do with the weapon?" He answers his own question: "I want to kill the infidels [non-believers]."
A senior officer in the CTU, who cannot be identified for security reasons, said: "We believe this was filmed abroad. We have no idea who the children are. We were shocked to find it at the house. We have no reason to believe this is faked. The guns are real."
Police say they have also found flash cards, used to teach young children the alphabet, in another house raid.
The officer said: "We found a series of flash cards and documents on how to raise Mujahid children [who will fight for Islam]. The cards were written in English - and instead of having M for Muhammad they had M for Mujahideen. They have the potential to indoctrinate. It just shows the mindset of some people and what we are up against."
Police say they also found documents downloaded from an extremist website which instructs parents to raise Mujahid children.
The documents say: "The key is to start instilling these values in them while they are babies. Don't wait until they are seven. No child is ever too young to be started off on Jihad training."
'Awful to see'
David Thompson, Assistant Chief Constable of Greater Manchester Police, said the majority of the Muslim population supported the police's counter-terror operations in the region. He said: "My view is [that] the majority of the community across the board see the threat that we're dealing with and are hugely supportive."
MP Kim Howells, chairman of the parliamentary intelligence and security committee, was shown the footage. He said: "It's a dreadful thing to see and I hope I never have to see it again actually. That's as serious a piece of evidence of the kind of thing we are up against as I have ever set eyes on."
Anjum Anwar MBE, who works for the church as a community dialogue development officer, said the film must not be used to implicate the rest of the Muslim world. Most of the Muslim community do not bring up their children in that way, she said.
Source has clips from the video- no kidding, it's terrifying.