The gunman relayed his demands through hostages who spoke to Network Ten news channel.

According to the report, the armed man had told the hostages that he had planted four bombs.

The gunman said two bombs are planted inside the Lindt Chocolate Cafe in Martin Place and the others elsewhere in the Central Business District, Sky News channel reported quoting Network Ten.

He also demanded delivery of an Islamic State flag and a conversation with Abbott. Network Ten reportedly spoke to two hostages inside the cafe, who were hysterical as they relayed the man's demands.

"The man, who reportedly forced hostages to call him 'the brother', said he would release a captive if the flag was delivered," it said.

Meanwhile, New South Wales police has activated Task Force Pioneer, signalling that the situation was now being treated as a terrorist attack.

NSW deputy commissioner Catherine Burn confirmed the task force had been activated just before 4pm local time.

Burn made the announcement moments after three men managed to escape from the Lindt Chocolat Cafe, six hours after the hostage situation began.

No confirmation has been made in relation to total number of people inside the cafe.

"We still don't know what the motivation might be," Burn said.

"But in terms of our protocols we've set up our command and control protocols." Burn said adding an exclusion zone is in place.

"We have a perimeter set up and the perimeter is around Hunter Street, Pitt, King and Elizabeth [streets]," she said.

"Aside from trains not stopping at Martin Place, the network is operating as it normally would."

Burn said police negotiators had made contact with the gunman but his motive was still not clear and warned that it was unhelpful to speculate what might have sparked the attack.

"Police negotiators have had contact and they continue to have contact and we will work through this," she said.

"As long as nobody gets hurt, we want to resolve this peacefully. That's what we are working towards," she added.