"The bomb was found following a tip off," said a police official in Kandy, 72 miles (116 kilometres) east of here by road.
"A search operation is under way to see if there are more bombs."
The festival attended by tens of thousands of local and foreign tourists involves the parading of Buddha relics carried in a golden casket placed on a decorated elephant.
The pageant which starts after sunset Sunday will go ahead, officials said.
Sri Lanka's Supreme Court had been highly critical of police security arrangements in Kandy where the sacred Temple of the Tooth, a relic shrine to the Gautam Buddha, is located.
Tamil Tiger rebels bombed the temple using an explosives-laden truck in January 1998, killing a total of 16 people, including 13 Buddhist pilgrims.
The annual pageant culminates with a street procession involving dozens of elephants on Tuesday.