The Lindt cafe in the city centre is surrounded by armed police. Officers have made contact with the gunman.
Five people have been seen running from the building. It is not clear how many remain inside. A black Islamic flag has been displayed at the window.
Prime Minister Tony Abbott said it was "profoundly shocking" that people were being "held hostage by an armed person claiming political motivation".
He was speaking after chairing a meeting of the national security committee in Canberra.
Earlier Mr Abbott said: "Australia is a peaceful, open and generous society - nothing should ever change that and that's why I would urge all Australians today to go about their business as usual."
Senior police officers say they are on a footing "consistent with a terrorist event".
The incident began as people were arriving for work in Martin Place on Monday. Witnesses saw a man with a bag and gun walk into the Lindt chocolate shop and cafe.
Lindt said about 10 employees and 30 customers were thought to be inside at the time. Nearby offices were evacuated and police asked people to remain indoors and away from open windows.
The BBC's Jon Donnison in Sydney says an enormous police operation is in place, on a scale few Sydney residents will have seen.
About six hours into the siege, three people were seen running from the building housing the cafe. Two more people followed about an hour later. It is not clear whether they escaped or were released.
New South Wales Police deputy commissioner Catherine Burn said: "Those people are now being assessed to make sure their health is okay and then police will talk to them."
"Our approach is to resolve this peacefully. It might take a bit of time but that is our priority," she added.
Police have identified the gunman and he is well known to them, Australian media report.
News organisations also say the suspect has contacted them to issue demands, which police have urged media not to report.
Channel 7, a broadcaster with offices facing the cafe, said lights inside the premises were turned out as night fell.
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