Queenstown Lakes District Council general manager engineering services Mark Kunath explained e-coli was an "indicator bacteria", usually found in the gut.
Because the the weekly test samples were taken from pipes and taps, the sample could well have been flawed, he said.
"As a precaution, we will always ask residents to boil their water, even with the slightest possibility for contamination," Mr Kunath said.
News of the possible contamination unsettled residents.
Mother of a young child Mia Bennie was anxious about the situation.
"This is a community with a large concentration of young children. If there is really an e-coli contamination, it is very serious. Children can die from that," Ms Bennie said.
Resident Peter Roberts said: "I was very concerned to hear there is e-coli bacteria in our water supply. When I researched the issue, I saw this bacteria is often linked to sewage leaks. I wondered if sewage could also leak into our water supply."
Mr Kunath said there was no possibility of a sewage leak affecting the reservoir.
"Nothing can seep into the bore or reservoirs. It is a closed system. We took a sample from the Manse Rd reservoir, and it showed no sign of the bacteria."
The issue had also added to the current discussion about allowing development to expand beyond Arrowtown's current boundaries, with fears the water supply and sewerage system would be put under pressure.
However, the council said the water supply was adequate for growth.
"The two bores in Arrowtown are a reliable source. If the council's recommendations of minimising unnecessary use of water is followed, and if leaks are repaired, there will be no shortage of water in the area, even if the town was to expand," Mr Kunath said.
Council senior 3 water service engineer Bernard Robinson, promised further tests would be carried out.
"Testing will continue over the next few days and contractors will be flushing the water lines to ensure any residual contamination is flushed to waste," Mr Robinson said.
Mr Kunath pointed out the water in Arrowtown was not chlorinated, which was also the case in Hawea, where tests showed e-coli two weeks ago.
"Residents have wanted the water supply to stay unchlorinated. But it also means there is nothing to kill the bacteria which might be found there. If further tests show bacteria, we might have to consider chlorinating to clean the system," he said.
If three days of tests show no contamination, an all-clear will be given.
Until then, residents should boil drinking water.
