Dozens of hostages were trapped inside a central Sydney cafe on Monday, with local television showing some being forced to hold up a black flag with white Arabic writing in the window, raising fears of an attack linked to Islamic militants.
Prime Minister Tony Abbott, who has warned of militant plans to attack Australian targets, said he was convening a meeting of the cabinet's national security committee for a briefing on the hostage situation at the Lindt Cafe in the country's commercial capital.
"Police are dealing with an armed incident and specialist officers are attempting to make contact (with) those inside a cafe," New South Wales Police said in a statement.
Australia, which is backing the United States and its escalating action against Islamic State in Syria and Iraq, is on high alert for attacks by radicalised Muslims or by home-grown fighters returning from the conflict in the Middle East.
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.
Dozens of heavily armed police surrounded the cafe in Martin Place, home to the Reserve Bank of Australia, commercial banks and close to the New South Wales state parliament.
Television 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. It was unclear how many assailants were involved.
A couple of hundred people were being held back by cordons and the fire brigade's hazardous unit was on the scene, a Reuters witness said.
The Reserve Bank of Australia, near the cafe, said staff had been locked down inside the building, and were all safe and accounted for.
The nearby Sydney Opera House was temporarily evacuated after a suspicious package had been found, a staff member told Reuters. Tourists were being let back into the world-famous venue by early afternoon.
Trains and buses were stopped and roads were blocked in the area, with train operators saying there had been a bomb threat at Martin Place.
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.
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.