© Christine Mcginn/AAP
Police shot the gunman dead after discovering the body of another man in the foyer in the serviced apartment in Brighton, 11km south-east of Melbourne's central business district.
The Seven Network is reporting the gunman called the organisation saying "This is for I.S [Islamic State]. This is for al-Qaida."
Victoria police said it was investigating whether the incident was "terrorism related".
Channel Seven reporter Paul Dowsley reported that his newsroom was called by a man claiming to be linked to the incident. "My colleague could hear a woman screaming in the background," he said.
Police arrived at the Buckingham Serviced Apartments in Bay Street at about 4pm after receiving reports of an explosion. "It's believed he has a woman inside with him who he won't allow to leave," a police spokeswoman said at the time. The police attempted to negotiate with a man in one of the apartments.
Brighton resident Gemma was on the corner of Hillcrest Ave and Bay St when she heard gunshots. "They were really fast paced, quick, lots of them and we ran," she told the Australian Associated Press.
By 6pm, police had shot the gunman dead after he emerged from one of the apartments and opened fire on police. Police also discovered the body of another man in the foyer of the building.
Andrew Crisp, Victoria's deputy police commissioner, said police had not yet identified either of the dead men. The woman was injured, but her injuries are believed to be non-critical.
"We don't know who rang Channel 7. At this point we haven't confirmed the identity and terrorism is one line of inquiry." Crisp said: "We will certainly be working with Channel 7 in relation to that phone call."
A major investigation was under way and Crisp called for patience on Monday evening. Terrorism was one possible avenue being pursued as one line of enquiry, he said, but stressed it was "early days" and that a number of lines of inquiry were being investigated.
Police did not communicate with the man during the situation, he said. Police were working to verify his identity.
"Just before 6pm whilst police resources were in the vicinity of the serviced apartments a male has existed one of the services apartments and began firing at police members," he said.
"Police members returned fire and as a result the man who exited the serviced apartments was fatally shot. As a result of the gunfire three police members were injured."
Two were taken to hospital and one was treated at the scene.
The hostage is believed to be in her 20s.
While the initial reports were of an explosion, Crisp said it was likely the explosion was likely to have been gun fire.
Victoria's premier Daniel Andrews praised the work of officers and the Victorian police, who "sacrifice so much to keep us safe".
How events unfolded
4pm Police respond to a call about an explosion at an apartment building in Brighton. They find a dead man in the foyer, he appears to have been shot. They start trying to negotiate with a man inside an apartment, who was holding a woman against her will.
5.41pm Seven Network Melbourne newsroom gets a call from a woman who says she's involved in a hostage situation. A man takes over the phone call to say "This is for IS, this is for al-Qaida." Seven calls police to report the call.
6pm A gunman leaves the building and opens fire on police, injuring three of them. Police fire back and kill him. The woman is freed Two police officers are taken to hospital with gunshot wounds, a third is treated at the scene.
With the Australian Associated Press
"This is for I.S [Islamic State]. This is for al-Qaida."
That's when I shot him.