Schmidt said that Google was presented with data of internal monitoring of traffic between its servers where the government had reversed engineered protocols that exchanged random data between the company's servers.
"Google's position is we are outraged on this," he said. "It's government overreach, is the best way to explain it.
This kind of government surveillance is also a huge business risk, he said.
Because other governments do not want the U.S. breaching their citizens' data, they will begin to demand control over the servers of American businesses located in their country.
"If you're a member of the government from one of these countries, what are you going to do? You're going to say 'what can I do in my country to prevent this?'" he said.
"Well, the most obvious thing you can do is prevent all of those American services, and all of that snooping and so forth, by requiring data localization. By requiring servers be in your country under your control, which breaks the Internet."
Still though, Schmidt said that the U.S. still beats other countries for businesses because companies can fire back at the government.
"One of the great things about America is its OK to complain about this in public and we are doing so," he said. "We have taken legal actions, we have filed a lawsuit in a secret court, it's called a FISA court."
Google wants the right to be able to disclose information about the government's requests for user data. So far, it has been unsuccessful at getting the right to share that information. The Department of Justice denied their requests in a filing on Sept. 30. However, the company, along with other tech giants, responded with a new filing earlier this month calling for more explanation as to why they cannot disclose the information.
—By CNBC's Cadie Thompson. Follow her on Twitter @CadieThompson.