Two men are dead, three police officers were shot and a woman was taken hostage in a dramatic siege in the Melbourne bayside suburb of Brighton.

The officers killed the gunman during the shootout. Two were later taken to hospital with gunshot wounds, while the other officer was treated at the scene.

Police had not confirmed the identity of the gunman but a man reportedly called Channel Seven's newsroom during the standoff and said "This is for IS.  This is for al-Qaeda"

Police are investigating whether the incident is terror-related and counter-terror investigators were on the scene last night.

The suspect was shot dead by police in a volley of gunfire after the woman was taken hostage at the Buckingham Serviced Apartments in Bay Street.

The bomb squad is investigating suspicious packages found in the apartment block and an unknown number of people are still believed to be trapped inside apartments.

Dozens of residents who were returning home from work and live near the apartment block  were told to come back in the morning as police are expected to remain at the scene overnight. 

Channel Seven reporter Paul Dowsley said police had told the network the phone number that linked the attack to terror groups matched the gunman's mobile number.

Dowsley told radio station 3AW the receptionist who took the phone call said the voice on the phone had "chilled her to the bone".

The receptionist said the caller "seemed very firm and the woman in the background was clearly distressed".

Mr Dowsley said the receptionist regularly took calls from members of the public but this one "stopped her in her tracks".

It is understood a man killed by the gunman was an employee of the serviced apartments. The female hostage is also believed to have worked at the apartments.

Police had arrived at the apartment block to find a man's body in the foyer while the suspect was holed up in one of the apartments with the woman.

Dozens of gunshots rang out just after 6pm in Bay Street with crowds of people fleeing and taking refuge in a nearby Coles supermarket.

A number of residents were trapped in the apartment block during the shootout.

About 6.20pm police removed what appeared to be a body on a stretcher from the apartment block.

Deputy Police Commissioner Andrew Crisp said police were investigating the relationship between the gunman and the female hostage, who is aged between 20 and 30.

The call to Channel Seven is believed to have come from within the building. A woman could be heard screaming in the background.

Two of the shot police officers were taken to hospital and another treated at the scene, police said. None has life-threatening injuries.

Jack Reid, 20, of Brighton said he and his friends had run for their lives after hearing gunfire.

"I was standing on the corner across the road," he said.

"I saw police pull out their guns, I heard about three dozen gun shots. I got really scared and ran across the road. Police were telling everybody to get into the Coles supermarket so me and mates just ran."

Kate Forster said she saw fire crews hiding behind their truck, empty cars left in the middle of the road and people stuck in the building next door to the siege.

"Can see them in the window looking distressed," she said from the scene.

Police were called to the serviced apartments at 4pm after reports of an explosion. 

Police then tried to negotiate with a man in one of the apartments who had taken a woman hostage.

Graeme Hisgrove said he, his wife and teenage children had to hit their lounge room floor because of a volley of gunfire coming from the serviced apartments next to their house just after 6pm.

"We've all hit the deck on our lounge floor," Mr Hisgrove said.

He said tactical police were inside his property against the fence line.

Mr Hisgrove said he heard a single gunshot on the other side of his fence between 4 and 4.30pm.

"It was one single bang. It was massive," he said.

He went out the front of his house and police had already surrounded the premises.

He said he and his family were now "waiting it out" inside their home.

"We're a bit on edge," he said.

Mandy Sharp was at Brighton Swim School Aquatics on Bay Street with her two children when police evacuated about 30 people about 5pm. 

Children in the middle of swimming classes were taken out of the pool as families and staff fled the scene.

Ms Sharp said people could smell the gunpowder in the air. 

"We were all a bit nervous and a bit scared, she said. "We were trying to keep calm for the kids though." 

Ms Sharp returned to the scene about 10pm to pick up her car but was told by police she would have to wait until Tuesday morning, with parts of Bay Street still blocked off. 

Antonia Waite, who lives off Bay Street, said her daughter was in the front yard when police, armed with "big guns", drove past about 4.30pm and told her to "go inside and lock the doors".

A number of callers said they saw undercover armed police with bulletproof vests running up the street.

One person said police had arrested a person and who was handcuffed at a bus stop in Bay Street.

Another caller, Georgie, said she had seen police officers on their hands and knees with guns drawn at the entrance to the apartment block.