The incident happened at the Lindt Chocolate Cafe in Martin Place, the heart of Sydney's business district.
Authorities sealed off surrounding streets, evacuated people from buildings, and suspended rail services following the siege in the capital of New South Wales (NSW).
NSW Police have activated Task Force Pioneer, which they use in terrorism related incidents, to handle the pre-Christmas incident.
Andrew Scipione, the commissioner of the New South Wales police, said at a news briefing that an unknown number of hostages were being held in the cafe by at least one gunman.
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Bengaluru-headquartered Infosys said one of its employees is among the hostages at the cafe.
"We can confirm that one Infosys employee is among the hostages at the Lindt Cafe in Sydney," the company said in a statement without naming the person.
Just over five hours into the siege, five people, including a woman, were seen running out of the cafe. Two came out through the front door and one through the fire escape. It is still not known whether they were freed or escaped.
Television footage showed people inside the cafe with their hands pressed against the window holding the black flag with Arabic script known as Shahadah, a prayer spoken in mosques daily. The flag displayed was not one specific to the Islamic State, reports said.
The gunman is being described as being in his forties, wearing a black vest. Police said they are in contact with the gunman.