A suspected terrorist who killed a man and took a woman hostage in an up-market suburb of Melbourne overnight had arranged to meet her through an escort service.

Police are treating the deadly siege as an "act of terror".

The fatal standoff, which ended in a volley of gunfire, saw a man murdered, the woman taken hostage, three officers shot, and the gunman killed by police.

The armed hostage-taker, identified by the police as Yacqub Khayre, was known by counter-terrorism police and had been on parole.

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Police have this morning revealed the gunman had arranged to meet a woman at the Buckingham Serviced Apartments in Brighton after booking her services through an escort agency.

Victoria Police Commissioner Graham Ashton this morning told ABC the man shot an employee of the building before taking the woman captive.

"At the scene, when this person's first arrived there, a man was shot, we believe, by the gunman," Ashton said. "He was an employee of the serviced apartments, so he appears to have been in the wrong place at, unluckily, the wrong time."

Ashton said Khayre had arranged to meet the woman.

"He's arranged to meet her as part of an escort service and he's booked her services and he's met her there for the purposes of those services of the escort agency."

Islamic State's media arm has this morning released a statement claiming Khayre, who is reported to have been involved in a failed plot to attack an Australian military base, was "a soldier of ISIS".

The siege began at Buckingham Serviced Apartments in the up-market bayside suburb of Brighton on Tuesday evening.

Heavily armed police swarmed the area when a female hostage, believed to be in her 20s, made a triple-0 call telling officers she was being held hostage and a man had been killed.

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"An act of terror"

The first sign of a possible terror link came when a male caller claiming to be linked to the siege called the Channel 7 newsroom in Melbourne saying: "This is for IS" and "this is for Al-Qaeda."

Seven reported a woman was heard screaming in the background of the call.

The siege came to a dramatic end when the gunman opened fire on police, hitting three male police officers, two of whom were hospitalised with gunshot wounds while the other was treated at the scene.

Tactical officers shot dead the gunman in a volley of gunfire.

Witnesses to the Brighton siege described hearing explosions and screams before a hail of machinegun fire brought the standoff to an end about 6pm.

Officers said they had no communication with the gunman during the two-hour siege and were yet to establish whether the call to Seven was genuinely related.

But Ashton has this morning confirmed police are treating the incident as terrorism.

"We are treating it as an act of terrorism," he told Seven's Sunrise.

"We don't know whether it was something planned or just spontaneous at this stage, but to answer your question we are treating it as a terrorism incident."

Ashton confirmed Khayre had "a long criminal history" and was on parole at the time of last night's siege.

The commissioner will provide a public update on the investigation, and address fears of terrorism in a media conference Tuesday morning.

Bomb squad police are seen in Bay Street in Brighton in Melbourne. Photo / AAP
Bomb squad police are seen in Bay Street in Brighton in Melbourne. Photo / AAP

Gunman "was on parole"

The gunman, claimed by the terror group to be a "solder of ISIS", had come to the attention of counter terror authorities almost a decade ago.

Khayre had been involved in a 2009 terror plot to attack Holsworthy Army barracks in Sydney's southwest.

The plan was traced back to followers of a Somali-based terror group with strong links with Islamic State. Khayre is reported to have been Somali refugee who lived in Australia since he was a child.

Investigators thwarted the plot that if successful could have seen Australian soldiers killed with high-powered weapons.

The plan, known as the Neath plot, saw three men convicted and handed lengthy jail sentences.

However Khayre and another man involved were acquitted in 2010.

In 2007, he was charged with armed robbery after holding up passengers on a Melbourne train, leaving one man with knife wounds.

Khayre was convicted of a number of crimes since walking free from the Holsworthy drama and had "recently done some jailtime", Ashton told ABC.

Khayre was released from prison last year and had been on parole since.

Isis claims responsibility

In statements released online Tuesday morning, IS blamed the attack on Australia's membership in the US-led coalition against the militant group.

"The attack in Melbourne, Australia was carried out by a soldier of the Islamic State in response to the call for targeting the subjects of the coalition states," the group's Amaq news agency said.

The incident comes weeks after the terror group's publisher called for IS followers in Australia to take hostages, suggesting sites like Gumtree and eBay could be used to place fake ads and lure potential victims.

It also follows the weekend's murderous London terror attacks that saw terrorists kill at least seven people "for Allah".

Deputy Commissioner Andrew Crisp said police had been on high alert following Saturday's attacks.

"We are extremely concerned about terrorism. Whenever there is any incident overseas it causes us to question what major events we have running," Mr Crisp told reporters at the scene on Monday night. "We are very attuned to the threat of terrorism here in Melbourne."