Police responded to reports of the sound of an explosion at around 4pm on Monday in the wealthy Melbourne suburb of Brighton.
When they arrived, they found the body of a man in the foyer of the serviced apartment building.
An alleged attacker and a woman he had taken hostage were barricaded inside.
Witness Graham Hisgrove told the ABC there was nothing people could do but wait to see what happened.
"I was out in the backyard, and I heard a large bang, and, when I went out on the street to see what was going on, all the police were there and told us to get back in the house. So I ran back into the house."
Another witness, Michelle Purcell, said she could see a police situation unfolding from her window.
"It was a bit scary, looking out the window and having (to) watch them set up their guns, so I knew at that point that there was something more serious going on."
In the ensuing shootout, several officers were injured as the man left the building and opened fire and police returned fire.
The woman, an employee of an escort agency booked by the man, escaped unharmed.
The man killed was an employee at the apartments.
The suspect has been named as 29 year-old Yacqub Khayre, who was on parole at the time of the attack.
He had also been acquitted in the 2009 Holsworthy army-barracks plot in Sydney, where three other men were found guilty of planning a terrorist attack.
The three were part of a cell that planned to enter the barracks with military weapons and shoot as many people as possible before they were killed or stopped.
Victorian premier Daniel Andrews has been quick to defend his state's record on parole.
"We have the toughest parole regime anywhere in our nation. That is a good thing. But the important point to note here today is that not only was he eligible and received parole but it would appear on the advice to this point that he had been compliant with the terms and conditions of the parole that had been granted to him. We'll look at that very closely, of course, and, as I said, if there are any changes in any element of this act, which we're considering as an act of terror, then we stand ready to make them."
Mr Andrews says the circumstances around Khayre's parole will be investigated but are a separate matter from terrorism.
"I would point to the fact that the parole -- so, the sentence -- did not relate to terrorism acts. He was actually acquitted of charges in New South Wales, as we all know. The jail sentence and his parole was in relation to other criminal acts that weren't of a terrorism nature. Of course, it is of concern, I think, to all of us that somebody who would be compliant with each and every term and provision of the parole they had been granted and were eligible for could commit such a crime."
From early on in the incident, authorities had said they were investigating possible links to terrorism.
IS has claimed responsibility for the attack, issuing a statement calling Khayre one of its "fighters."
But Victorian police commissioner Graham Ashton has called for caution in accepting that as true.
"We're aware of, online, them having claimed responsibility, but then they always tend to jump up and claim responsibility every time something happens, so, uh, we note that that's happened but he's also made statements last night around al-Qaeda. We believe that he's made a call to Channel Seven making those sorts of comments as well. That's why we're treating this as a terrorism incident."
But he stresses Khayre's criminal background.
"Look, he has got a long criminal history going back many years. A lot of ... I describe it as an extensive criminal history involving a whole range of offences. He's recently done some jail time, got out late last year -- I think it was November last year -- and has been on parole at the time of this offending last night."
Investigations are ongoing.
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