Police said they knew of one armed assailant involved in the incident at the Lindt chocolate cafe in the heart of Sydney's financial district, but there could be more.
Police, including paramilitary officers, cordoned off several blocks around the cafe as negotiators tried to defuse one of the biggest security scares in Australia for decades. Snipers and a SWAT team took up positions around the cafe and police helicopters flew overhead. At least five hostages have been released or escaped since the mid-morning siege began, with terrified cafe workers and customers seen running into the arms of paramilitary police.
About 15 hostages could still be seen inside the cafe, said Chris Reason, a reporter at Channel Seven, whose office is opposite the cafe.
News footage showed hostages holding up a black and white flag displaying the Shahada - a testament to the faith of Muslims. The flag has been popular among Sunni Islamist militant groups such as Islamic State and al Qaeda.
The incident forced the evacuation of nearby buildings and sent shockwaves around a country where many people were turning their attention to the Christmas holiday following earlier security scares.
In September, anti-terrorism police said they had thwarted an imminent threat to behead a random member of the public and days later, a teenager in the city of Melbourne was shot dead after attacking two anti-terrorism officers with a knife.
The siege cafe is in Martin Place, a pedestrian strip popular with workers on a lunch break, which was revealed as a potential location for the thwarted beheading.
"We're possibly looking at a lone wolf who has sympathies to global jihad or someone with mental health issues in search of a cause," said Adam Dolnik, a professor at the University of Wollongong who has trained Sydney police in hostage negotiations. "This is all about attention."