UPDATE: Five hostages run out of Sydney siege cafe

A square in the heart of the Australian city was evacuated as hundreds of armed police surrounded the Lindt chocolate cafe, where a flag -- black with white Arabic writing -- was held to a window by customers.

It appears to be the shahada, or profession of faith in Islam, and says: "There is no god but Allah; Muhammad is the Messenger of Allah."

Some six hours into the siege, three men emerged from the popular cafe and ran for their lives, two from the front door and one from an emergency exit. Around an hour later two women also fled.

It was not clear if they escaped or were released.

New South Wales state deputy police commissioner Catherine Burn said negotiators "have had contact and continue to have contact" with the armed person holding the hostages, but they did not know the motivation for the siege.

"We do not have information to suggest that anyone is harmed at this stage," she said, adding that the number of hostages "is not as high as 30" as some reports had suggested.

Australia has been on high alert after the government raised concerns that citizens who have fought alongside jihadists in Iraq and Syria could return home radicalised and capable of carrying out attacks.

State police commissioner Andrew Scipione said "we have not yet confirmed this is a terrorism-related event," despite Prime Minister Tony Abbott convening a national security meeting to deal with the "disturbing" development.

"We don't yet know the motivation of the perpetrator, we don't know whether this is politically motivated, although obviously there are some indications that it could be," Abbott said, while urging people to get on with their daily lives.

The White House said US President Barack Obama had been briefed about the crisis.

Patrick Byrne, a producer at Channel Seven whose newsroom is opposite the cafe, said staff at the television station watched the situation unfold.

"We raced to the window and saw the shocking and chilling sight of people putting their hands up against the panes of glass at the cafe," he told the Australian Broadcasting Corporation.

"This was just extraordinary."

The scene of the drama, Martin Place, is Sydney's financial centre and houses several prominent buildings, including the New South Wales parliament, the US consulate, the country's central bank and the Commonwealth Bank of Australia.

Many shops in the area opted to close early due to the scare, with only a trickle of people walking along usually bustling streets.

At the nearby Sydney Opera House, where police had swept the area earlier Monday, evening performances were cancelled.

"It's sad to think this is my home and that it could happen anywhere," said onlooker Rebecca Courtney.

The cafe incident came just minutes before police announced a man had been arrested in Sydney on alleged terrorism offences.

They said the 25-year-old was seized as part of "continuing investigations into the planning of a terrorist attack on Australian soil and the facilitation of travel of Australian citizens to Syria to engage in armed combat".

Scipione said he did not believe the matters were related.

The government in September raised its terror threat level and police conducted large-scale counter-terror raids across the country. Only two people were charged even though 800 officers were involved in the operation.

More than 70 Australians are believed to be fighting for Islamic militants in Iraq and Syria. At least 20 have died and there are growing concerns about youths becoming radicalised and mounting attacks at home.

Journalist Chris Kenny, who was in the Lindt cafe just before the siege began, said he understood the automatic glass sliding doors had been disabled.

He added that a woman who tried to get in as he was leaving saw someone with a weapon.