The unnamed man drove a 4X4 truck loaded with gas bottles into the bustling city centre of Melbourne, ignited the vehicle in a ball of flames and then attacked passers-by with a knife, police said.
Chilling footage uploaded to social media shows the suspect repeatedly swinging the weapon at two officers before one of them draws their firearm and opens fire.
"Three people have been stabbed, unfortunately one of them is deceased at the scene", David Clayton, police superintendent of Victoria state, told reporters.
The man shot by police after he stabbed three people in Melbourne's Bourke Street has died in hospital.
Ashton didn't give the Somali attacker's name, but said the man had "family associations that are well known to us".
The police officers are being treated for cuts and scrapes and are not thought to be in a serious condition.
Two survivors were rushed to hospital for treatment - one in a suspected critical condition.
In more footage, a man is seen lunging at police before he is shot.
While police initially believed the incident wasn't terror related, the Herald Sun has since reported the man was known to ASIO.
Police later said the auto from which the slain suspect, a Somali national, had emerged, contained gas cylinders and was on fire when they arrived.
Police shot the man in the chest and he was taken to the Royal Melbourne Hospital.
Police said officers "initially responded to a report of a auto on fire" in the city centre at 4:20 pm local time, but discovered at the scene that members of the public had been stabbed.
Sky News Australia's Patrick Murrell said police had tried to "talk [the suspect] down and tried to use the Taser" before shooting him. One of the victims died from his injuries.
The Islamic State claimed responsibility for the attack and authorities say they are investigating it as an act of terrorism.
"Because he was on his stomach, they turned him over to see if he's all right, he was still alive", the witness, Markel Villasin, told Australian Associated Press.
"Anyone with information or who witnessed the incident is asked to go to Melbourne West Police Station to make a statement".