This study investigates the neural correlates and processes underlying the ambiguous percept produced by a stimulus similar to Deutsch's ‘octave illusion’, in which each ear is presented with a sequence of alternating pure tones of low and high frequencies. The same sequence is presented to each ear, but in opposite phase, such that the left and right ears receive a high–low–high … and a low–high–low … pattern, respectively. Listeners generally report hearing the illusion of an alternating pattern of low and high tones, with all the low tones lateralized to one side and all the high tones lateralized to the other side. The current explanation of the illusion is that it reflects an illusory feature conjunction of pitch and perceived location. Using psychophysics and electroencephalogram measures, we test this and an alternative hypothesis involving synchronous and sequential stream segregation, and investigate potential neural correlates of the illusion. We find that the illusion of alternating tones arises from the synchronous tone pairs across ears rather than sequential tones in one ear, suggesting that the illusion involves a misattribution of time across perceptual streams, rather than a misattribution of location within a stream. The results provide new insights into the mechanisms of binaural streaming and synchronous sound segregation.