A gunman has taken dozens of people hostage in a cafe in Sydney's financial district.
Two Arabic flags similar to those used by Islamic State have been seen inside the Lindt chocolate shop and cafe in Martin Place.
The hostage taker has reportedly claimed to have four bombs - two inside the cafe and two in the financial district.
Channel Ten has spoken to two hostages who say the gunman has demanded a meeting with Australian Prime Minster Tony Abbott and wants an IS flag delivered to the cafe.
Some of the hostages have spoken to their families on mobile phones - while five, three men and two women, have managed to escape.
Australian police said negotiators had been in contact with the "armed offender" inside the cafe - but refused to speculate on his possible motivation.
The gunman - who has reportedly contacted several media outlets from the cafe - has been seen using hostages as human shields.
New South Wales Police deputy commissioner Catherine Burn described it as a "sensitive negotiation" and said there was nothing to suggest anyone had been harmed.
Martin Place - home to the Reserve Bank of Australia, commercial banks and close to the New South Wales state parliament - has been closed off and up to 100 heavily armed police are surrounding the area.
Earlier, live television footage showed patrons inside the cafe standing with their hands pressed against the windows.
Hostages were also seen holding a black flag with white Arabic text.
According to reports, the gunman, who is wearing a black bandana with white writing on it, walked into the cafe just before 10am local time.
A Lindt executive said there were about 10 staff and "probably 30 customers" in the cafe - but police later said the number was "not as high as 30", although they did not give further details.
The Australian Prime Minister said he has convened the National Security Committee for emergency briefings following the "hostage-taking situation".
"This is obviously a deeply concerning incident but all Australians should be reassured that our law enforcement and security agencies are well trained and equipped and are responding in a thorough and professional manner," said Mr Abbott.
Mr Abbott said he did not yet know the motivation of those holding the hostages, adding: "Our thoughts and prayers must above all go out to the individuals who are caught up in this.
"I can think of almost nothing more distressing or terrifying than to be caught up in such a situation, and our hearts go out to those people."
Police have now confirmed they are working "on a footing" it is a terrorist incident - but they remain confident a peaceful resolution can be achieved.
Several buildings in the area have been evacuated, including the Channel 7 newsroom opposite the cafe, and staff at the Reserve Bank of Australia are in lockdown inside the building. All are said to be safe.
Meanwhile, Sydney Opera House has been evacuated after a suspicious package was reportedly found not long after the police operation in the financial district began.
Police confirmed they were dealing with an "incident" there, but said it was not linked to events at the cafe.
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Gallery: Latest Images From Australia
Two hostages run for cover behind a policeman during a hostage siege in the central business district of Sydney
A woman runs for freedom from Sydney's Lindt chocolate shop and cafe in Martin Place
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