Television footage earlier showed three of the hostages running from the building. New South Wales Deputy Police Commissioner Catherine Burn declined to say how many were still being held in the cafe but said it “is not as high as 30.”
Burn told reporters there was no indication that any of the remaining hostages had been harmed.
Senior police officers say they are on a footing “consistent with a terrorist event” after a flag with Islamic writing was unfurled inside the restaurant.
Hundreds of armed police have sealed off Martin Place in Sydney’s central business district.
Police say an armed man has taken an undisclosed number of hostages at a café. Reports suggest that 10 members of staff and up to 30 customers are inside.
Pictures on local television have shown some hostages with their hands up against a window, and a black flag with Arabic writing.
Australian Prime Minister Tony Abbott has described the incident as “deeply concerning.” He added that the motivations of those responsible were not yet clear.
New South Wales police Commissioner Andrew Scipione indicated a huge security operation was underway.
“We are at this stage continuing to secure and make sure that we are doing all we can to bring this to a peaceful outcome. We want this matter resolved peacefully, and we will do all we need to ensure that,” said Scipione.
Earlier this year, Australia raised its domestic terror threat level from medium to high, mainly due to concerns about home grown extremists.
About 70 Australians are thought to be fighting for militant groups in the Middle East.
In September, Australia’s largest counter-terror raids took place in Sydney and Brisbane. One person was charged with terror offences.
Tough anti-terror laws were passed by the Australian parliament in October in response to the threat of homegrown extremism.