The Islamic State group says one of its fighters carried out a knife attack in Melbourne in which one man died and two were wounded.

The group's Amaq news website provided no evidence for the claim.

"The one who executed the ramming and stabbing operation in Melbourne (..) is one of the fighters of the Islamic State and he executed the operation in response to (a call) to target the citizens of the coalition," Amaq said on Friday.

The text was referring to a call in August by Islamic State leader Abu Bakr al- Baghdadi to "use bombs, knives or cars to carry out attacks" in countries taking part in the US-led coalition that put an end to the caliphate he declared in 2014 over parts of Iraq and Syria.

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The attacker in Melbourne was shot by police after he set fire to a ute laden with gas cylinders in the centre of Melbourne and stabbed three people, killing one. The attacker died later in hospital.

Police are now treating the stabbing attack in Melbourne's Bourke St as a terrorism incident.

The knifeman, a 31-year-old Somali-born from Melbourne's north-western suburbs, died in hospital on Friday night after being shot in the chest by police.

Police have not yet revealed the identity of the attacker or the other man who died.

But The Daily Mail has named the attacker as Mohamed Khalif, who also reportedly goes by the name Hassan Shire.

Khalif's 21-year-old brother, Ali Khalif Shire Ali, was arrested in November of 2017 in relation to an alleged foiled terror attack in Federation Square, also in the heart of Melbourne, Daily Mail reported.

The Herald Sun, on its Twitter page, said the terrorist's wife "was missing and is believed to have been radicalised". They say Victoria Police are searching for her.

In a press conference Victoria Police Chief Commissioner Graham Ashton said the man who is alleged to have stabbed three people, killing one, was known to Victoria Police and federal intelligence authorities.

"We are now treating this as a terrorism incident," he said.

Commissioner Ashton revealed the man came to Australia from Somalia in the 1990s and had relatives known to police from a "terrorism perspective".

"He's got family associations that are well known to us," he said.

There were some reports that the man yelled "Allahu Akbar" during the attack but Commissioner Ashton said this had not been confirmed.

The attacker had a record of some minor offences including for cannabis use, theft and driving offences.

The man caused chaos in the Melbourne CBD on Friday afternoon after allegedly stabbing three men. One man, who is yet to be formally identified, died at the scene. Some witnesses say he was stabbed in the face.

A 26-year-old and a 58-year-old were taken to hospital with non-life threatening injuries.

Police officers also received minor injuries, one of them from being punched, and some cuts and scratches.

Bourke St is in lockdown from Swanston St to Russell St and is expected to remain closed until as late as 8am Saturday as police investigate.

The Herald Sun is reporting one of the men injured in the attack was Rodney Patterson and his wife Maree posted on Facebook that he was "doing ok given the circumstances".

In light of the attack police are doing security assessments of events happening in Melbourne this weekend and extra police may be present but the Commissioner said there was no ongoing threat they were aware of.

Victorian Premier Daniel Andrews condemned the incident and thanked the police and brave bystanders who had risked their lives to stop the knifeman.

"This is an evil, terrifying thing that's happened in our city and state today," Mr Andrew said.

"We condemn it. We also take this opportunity to thank those very brave and dedicated members of Victoria Police who did all of us proud in their very quick response in very dangerous circumstances. They've done each and every one of us proud.

"Equally, those strangers, people who were bystanders who knew nobody involved, who stepped in without a moment's hesitation, to render support and assistances."

Prime Minister Scott Morrison said he had been briefed about the incident and state and federal agencies were working together.

"I condemn the act of terrorism in Melbourne today that has tragically taken the life of a fellow Australian who has died as a result of this evil and cowardly attack," he said in a statement.

"Australians will never be intimated by these appalling attacks and we will continue to go about our lives and enjoy the freedoms that the terrorists detest."

HOW THE ATTACK UNFOLDED

The incident began when the man drove a 4WD into the city about 4.10pm and it was set on fire. Commissioner Ashton confirmed there were some barbecue-style gas cylinders in the car that had to be rendered safe by the bomb response unit.

It's unclear whether the car was set on fire before or after the man left the vehicle.

According to the ABC, witnesses saw the man crash the car, get out and throw an object into the car that set it alight.

Commissioner Ashton said after the car was set on fire, the man interacted with some members of the public before police arrived.

The man then punched one of the officers through the window of the car. Two other officers got out of the police vehicle and attempted to engage him but the man used a knife to try and attack them. One officer eventually shot him once in the chest.

Footage on social media shows a blue ute up in flames and a man dressed in a black tunic and white pants menacing police with what appears to be a knife. Two bystanders try to help officers stop the man, one of them by rolling a shopping trolley in his path.

Markel Villasin, 22, was finishing his shift at KFC on Bourke St as the drama unfolded.

"Me and the managers ran out and that's when we saw the car on fire and then we saw the guy on the floor and we wanted to help, there were two blokes helping him out already, he was face down pools of blood around his face," he told AAP.

"I'm pretty sure he got stabbed in the face.

"I really wanted to help but I was in shock, I didn't know what to do.

"Because he was on his stomach, they turned him over to see if he's alright, he was still alive."

Bystander Drew Hair told AAP he was walking on Swanston Street when he heard an explosion.

The next thing he saw was a "big dude punching into the police car".

Mr Hair said the assailant was dressed in Islamic clothing and of African appearance and about six foot four inches tall.

"The cops were trying to hit him with batons and he wasn't going down," he said. Mr Hair said two civilians became involved as well as two police, trying to stop the man from his attack.

Melbourne resident Meegan May told news.com.au she was on a tram on Bourke St heading into the city when it stopped just before Elizabeth St, about a block before the mall. She heard someone start screaming "he's got a knife".

She looked through the back window of the tram and noticed a car on fire. There was a man and two police officers trying to calm him down.

"A moment later, I heard a loud bang; to me it sounded like a gunshot," she said.

An ambulance and about 10 police cars appeared within moments.

A man told Sky News that there seemed to be multiple explosions.

"There was one explosion and fire, then a second explosion and it was like a massive fireball," he said.

Reports on 3AW Radio indicate that witnesses saw the man driving the vehicle "throw something into the back", which then ignited.

An eyewitness speaking to 7 News said it appeared the car was on fire before it crashed and "exploded".

"I was walking up Bourke St … and we heard this loud explosion. I thought it was a car backfiring but there was flames coming out of the car. It then veered to the left … and exploded in flames," the woman said.

"People were running everywhere. I thought it was like what happened last year so I started running. Everyone started running. It was so scary."
The area has been cordoned off and the public are urged to avoid the area.

Police say they are not looking for anyone further at this early stage.

Anyone with information or who witnessed the incident is asked to go to Melbourne West police station to make a statement.

The incident comes as a trial into the 2017 rampage in Bourke Street continues.

In 2017, six people died in the terrifying car rampage that also left dozens injured.

Four adults, a child and a baby died after James "Dimitrious" Gargasoulas allegedly ploughed his car through the busy pedestrian mall on January 20.

Those killed were three-month-old Zachary Matthew-Bryant, Tahlia Hakin, 10, Yosuke Kanno, 25, Jessica Mudie, 23, and 33-year-olds Matthew Si and Bhavita Patel.

In September that year a knife-wielding man also went on a rampage outside Flinders St station. He was tasered and arrested in dramatic scenes in Melbourne's CBD.

In December, there was another incident when Saeed Noori allegedly drove a car into people crossing the intersection of Flinders and Elizabeth streets.

At least 18 people, including a four-year-old boy and international tourists, were hit by the car that afternoon and one of them, 83-year-old grandfather Antonio Crocaris, died about eight days later.