A man brandishing a gun and an Islamic flag took customers and staff hostage at a cafe in Martin Place, sparking a terrifying standoff with police and desperate communications by hostages of the gunman's purported demands.

On a day of brilliant  blue skies and a cooling breeze, the siege at the Lindt Cafe brought fear to the streets of summertime Sydney like no event since the terrorist bombing of the Hilton Hotel in  February 1978.

The cafe, associated with a Swiss chocolate company, has no obvious value to Islamist militants.

News of the siege - which took place opposite Channel Seven's city studios - was relayed almost instantaneous, with the drama unfolding throughout the day as petrified hostages called media outlets and posted remarks on social media to relay their captor's demands.

There was some joy when five hostages suddenly emerged from the building.

The siege began at 9.44am, Sydney time, when the man carrying the weapon and a packed backpack entered the cafe, swiftly sealing the venue.

Some of those inside were forced to stand at the window and hold up a black flag with Arabic script proclaiming Allah as the true God.

Grainy footage showed what appeared to be a middle-aged man wearing a black headband standing behind the petrified hostages.

As Australia – and the world – was transfixed by the unfolding crisis,  a massive and heavily armed police presence swarmed the building hosting the cafe as police negotiators sought a peaceful resolution to the crisis.

Snipers manned nearby rooftops and heavily armed members of the tactical response group swarmed the building that fronts Martin Place between Phillip and Elizabeth Street.

After almost six hours of tension, three hostages suddenly emerged from the building, two men through the cafe's main entrance while another – wearing an apron and apparently a staff member – fled from a nearby fire escape followed by a police officer.

About 90 minutes later, two women – wearing Lindt uniforms – also emerged, sprinting down Martin Place and into the arms of waiting police.

"We are being tested today in Sydney," NSW Premier Mike Baird said. "The police are being tested, but whatever the test, we will face it head on and we will remain a strong, democratic, civil society"..

NSW Deputy Police Commissioner Cath Burn confirmed that less than 30 hostages were inside, debunking early reports there were as many as 50 captured by the gunmen.

She said all appeared to be unharmed but declined to say if the five who left the building were released or escaped.

Among those taken hostage are lawyers, bankers and other workers from nearby offices..

The gunman forced hostages to call multiple media outlets to outline his demands and generate publicity, including Fairfax Media. The hostages also posted the chilling demands on their social media accounts.

Police have asked that media do not relay the demands due to the hugely sensitive negotiation with the hostage-taker currently underway.

Earlier on Monday, Queensland Police Commissioner Ian Stewart said it was "firming up" that there was an "improvised explosive device" involved in the siege.

Commissioner Burn was asked about the reports of a bomb but declined to confirm or deny them, saying it was important "not to completely over-react".

She said police believed the "situation was contained to one area at the moment".

NSW Police are leading the operation, having activated Taskforce Pioneer, which is put into effect if there is a suspected terrorist incident.

Even so, police were unwilling to speculate on the motives of the armed kidnapper. However, Mr Abbott said there were "some indications" the incident might be "politically motivated".

Police negotiators made contact with the man and are using a "a very, very well tested system of negotiation", according to Deputy Commissioner Burn said

As the CBD went into lockdown and office workers evacuated or ordered to stay in their offices and away from windows, Sydneysiders responded to the siege with a mixture of alarm, calm resolve and curiosity.

Sydney Opera House was evacuated after a report of a suspicious package, later ruled innocuous.

The Channel Seven building in Martin Place; NSW Parliament's executive offices; the State Library, the NSW Supreme Court and several legal chambers were also emptied on the orders of police.

While many office workers rushed home, some members of the public sauntered up Martin Place to take in the scene, taking photos and, in one case, bringing bottles of wine.

One anti-Islam activist arrived at the police cordon and launched a vicious diatribe denouncing the religion.

But he was rounded on by onlookers and told "Muslims are welcome here, mate".

Haidar Elsalim, one of those confronted by the man, said : "You can't judge what's happening here against all Muslim people. We are all deeply worried about what's going on inside that cafe."

Despite the CBD lockdown, most public transport remained on schedule and people were encouraged to return home from work in their normal manner.

"This is a very disturbing incident. I can understand the concerns and anxieties of the Australian people at a time like this but our thoughts and prayers must above all go out to the individuals who are caught up in this,"  Mr Abbott said.

"I can think of almost nothing more distressing, more terrifying than to be caught up in such a situation and our hearts go out to these people."

Opposition Leader Bill Shorten said "Australians are shocked but we won't be shaken."

"At times like this it is more critical than ever that the Australian community be solid, stick together and be united," he said.

Fairfax Media understands there were no plans on Monday evening to raise the national terrorism alert level.

Terrorism experts, while stressing much remained uncertain about the situation, broadly said the siege appeared to be the work of a "lone wolf" operator rather than part of a large and coordinated terrorism network.

Clive Williams of the Australian National University said the man was most likely inspired by the Islamic State group, though there did not appear to be any direction from or co-ordination with the larger network.

"Islamic State has been encouraging its followers to carry out low-tech, high impact attacks within the countries involved in the coalition in Iraq. And this is a classic example of that," Professor Williams said. "Mostly these guys have been encouraged to act off their own bat because Islamic State realises that if you try and get together a few people acting together, there's a good chance they'll be detected."

In Washington, the White House confirmed President Barack Obama had been briefed on the siege.

A spokeswoman for the US State Department, Jen Psaki, said: "We are closely following the security incident in Sydney.  Our hearts and prayers go out to those who are being held hostage."

The siege followed raids in Sydney's north-west by counter-terrorism police on Monday morning, although police insisted the events were unconnected.