An armed assailant was holding an unknown number of hostages inside a central Sydney cafe on Monday, police said, with local television showing some being forced to hold up a black flag with white Arabic writing in the window.
Prime Minister Tony Abbott, who has warned of militant plans to strike Australian targets, said there were indications the hostage situation at the Lindt Cafe was politically motivated.
"This is a very disturbing incident. I can understand the concerns and anxieties of the Australian people," Abbott told reporters in Canberra, without providing any information on the unfolding siege.
Australia, a staunch ally of the United States and its escalating action against the Islamic State in Syria and Iraq, is on high alert for attacks by home-grown militants returning from fighting in the Middle East.
Police had not had any direct contact with the hostage taker, said Andrew Scipione, police commissioner for the state of New South Wales.
"We have moved to a footing that would be consistent with a terrorist event," Scipione told reporters in Sydney.
A Lindt Australia executive said there were about 10 staff working at the cafe, Sky Business television reported. Chief Executive Steve Loane also said there were "probably 30 customers" in the cafe, according to Sky Business, although he stressed to another news outlet that he was guessing.
The hostage drama forced the evacuation of nearby buildings in Sydney's central business district and sent shockwaves around a country where many people have started to turn their attention to the approaching Christmas festive season.
In September, Australian anti-terrorism police said they had thwarted an imminent threat to behead a random member of the public and days later, a teenager in Melbourne was shot dead after attacking two anti-terrorism officers with a knife.
Evacuating by ladder
Dozens of heavily armed police surrounded the cafe in Martin Place around mid-morning. The area is home to the Reserve Bank of Australia, commercial banks and close to the New South Wales state parliament.
The cafe was directly opposite a commercial television studio and footage showed several people inside the cafe standing with their hands pressed against the windows.
Pictures showed a black and white flag similar to those used by Islamic State militants in Iraq and Syria being held up by what appeared to be a staff member and another woman.
A couple of hundred people were being held back by cordons and a police SWAT team and the fire brigade's hazardous unit were on the scene, a Reuters witness said.
Several hours into the siege, police led about two dozen people out of a building opposite the cafe and through the cordon. Others were evacuated from the building above the cafe by ladder, television pictures showed.
The Reserve Bank of Australia said staff had been locked down inside the building, and were all safe and accounted for.
The nearby U.S. consulate was also evacuated, according to an embassy spokeswoman, along with the Sydney Opera House. Tourists were being let back into the world-famous venue by early afternoon.
Banks and shops close
Major banks closed their offices in the central business district and people were told to avoid the area. Shops in a four block radius were shut.
"If it was up to me, I would storm the building," said John, a lawyer in his 50s who was evacuated from the building where the cafe was located. "I just feel angry about it." He declined to give his full name.
Qantas Airways Ltd said planes were avoiding flying over the central business district but were landing as normal.
Traders in currency markets said the hostage news may have contributed to a dip in the Australian dollar, which was already under pressure from global risk aversion as oil prices fell anew. The local currency was pinned at $0.8227, having hit its lowest since mid-2010 last week.
The prime minister of Canada, which suffered an attack on its parliament by a suspected jihadist sympathizer in October, offered his support.
"Canada's thoughts and prayers are with our Australian friends. #MartinPlace #SydneySiege" Stephen Harper said via social media.
Concerns about an attack in Australia by radical Islamists have been growing for more than a year, with the security agency raising its national terrorism public alert to "high" in September.
Security had recently been stepped up at the nation's parliament, airports and at large scale public events.