The auditory octave illusion arises when dichotically presented tones, one octave apart, alternate rapidly between the ears. Most subjects perceive an illusory sequence of monaural tones: A high tone in the right ear (RE) alternates with a low tone, incorrectly localized to the left ear (LE). Behavioral studies suggest that the perceived pitch follows the RE input, and the perceived location the higher-frequency sound. To explore the link between the perceived pitches and brain-level interactions of dichotic tones, magnetoencephalographic responses were recorded to 4 binaural combinations of 2-min long continuous 400- and 800-Hz tones and to 4 monaural tones. Responses to LE and RE inputs were distinguished by frequency-tagging the ear-specific stimuli at different modulation frequencies. During dichotic presentation, ipsilateral LE tones elicited weaker and ipsilateral RE tones stronger responses than when both ears received the same tone. During the most paradoxical stimulus—high tone to LE and low tone to RE perceived as a low tone in LE during the illusion—also the contralateral responses to LE tones were diminished. The results demonstrate modified binaural interaction of dichotic tones one octave apart, suggesting that this interaction contributes to pitch perception during the octave illusion.