One person has been killed on a central Melbourne street where a knife wielding man was left in a critical condition after being shot by police.
"We don't believe there is an ongoing threat at this stage, but certainly we are treating it as a terrorism incident".
Bystander Drew Hair told AAP he was walking on Swanston Street when he heard an explosion.
In a later statement, police said the man assaulted police, fled on foot, then was shot while lunging at police with the knife. It said the man was "one of Daesh's fighters" and had responded to calls for attacks in countries that are part of the global coalition fighting the militants in Syria and Iraq.
The two wounded stabbing victims were in the hospital.
This attack is being treated as a terrorism incident.
"Passers-by were calling out that members of the public had been stabbed", Supt Clayton said.
Witnesses say they saw the man drive a truck into the Target centre and as the vehicle caught fire he tried to fight and stab police and bystanders. As the attacks continued, one policeman shot the suspect in the chest, leaving him in a critical condition.
He did confirm the man arrived from Somalia in the 1990s and was known to police.
Police said the driver got out of the vehicle, which then caught fire, and attacked three bystanders with a knife.
Footage from the scene appears to show the man approach officers with the blade.
Bourke Street is now blocked between Swanston and Russell streets, and people are being advised to avoid the area.
"The exact circumstances are yet to be determined".
The police cordoned off the area and warned people from coming near the area.
A second person suffered a head injury and has been taken to hospital.
Video posted to Twitter and broadcast on television showed a man repeatedly swinging an object at two police officers in the downtown area of the city.
Melbourne was also the scene of two fatal car-ramming incidents previous year, but neither was linked by police to terrorism.