Victoria Police Chief Commissioner Graham Ashton said the man who stabbed three members of the public and attacked police officers has died in a hospital.
"We are now treating this as a terrorism event," said Ashton, adding that the suspect is "someone that is known to us".
''I'm not at liberty at this point to disclose the identity of that person. But we are, as I say, having counter-terrorism investigations under way. The person is known to police. He's known to police mainly in respect to relatives that he has that are certainly persons of interest to us. He is someone that, accordingly, is known to both Victoria Police and federal intelligence,'' Ashton said.
The man was shot after confronting police officers on a busy city street, authorities said. He was taken into custody in a critical condition. He succumbed to the gunshot wounds in the Royal Melbourne Hospital.
"The perpetrator of the operation... in Melbourne... was an Islamic State fighter and carried out the operation... to target nationals of the coalition" fighting the Islamic State, the terror group's propaganda outlet, Amaq, said.
Officers were initially called to reports of a car fire near Bourke Street, a busy thoroughfare, at about 4.20pm local time.
"As they got out of the car, they were confronted by a male brandishing a knife and threatening them," Supt David Clayton told reporters.
Ashton said a four-wheel drive Ute drove into Bourke street between Russell and Swanston Street and parked there. A male person was in that vehicle.
''Fire then started in the vehicle and he's got out of the vehicle. He then engaged with members of the public at that location,'' he said.
'The fire brigade turned up to put the fire out discovered there were gas bottle - I understand at this stage they are those barbecue-style gas bottles - within the vehicle," Ashton said.
Footage captured the shocking scenes as a car went up in flames and police shot the knife-wielding man in the chest after he confronted officers as they arrived at the scene.
Prime Minister Scott Morrison has said Australians will "never be intimidated by these appalling attacks".
Victoria Premier Daniel Andrews has called the attack an "evil and terrible thing".
Local media reports quoted 22-year-old Markel Villasin, who was finishing his shift at KFC on the Bourke St as the incident happened.
"Me and the managers ran out and that's when we saw the car on fire and then we saw the guy on the floor and we wanted to help, there were two blokes helping him out already, he was face down pools of blood around his face," Villasin said.
"I'm pretty sure he got stabbed in the face. I really wanted to help but I was in shock, I didn't know what to do. Because he was on his stomach, they turned him over to see if he's alright, he was still alive," he said.
According to a bystander, Drew Hair, he was walking on Swanston Street when he heard an explosion.
The next thing he saw was a “big dude punching into the police car”.
Hair said the assailant was dressed in Islamic clothing and of African appearance and about six foot four inches tall.
An eyewitness said it appeared the car was on fire before it crashed and “exploded”.
"I was walking up Bourke St … and we heard this loud explosion. I thought it was a car backfiring but there was flames coming out of the car. It then veered to the left … and exploded in flames," the eyewitness said.
"People were running everywhere. I thought it was like what happened last year so I started running. Everyone started running. It was so scary."