Police said knife-wielding man stabbed three people, one fatally, in Australia's second-largest city on Friday in an attack police linked to terrorism.

The unnamed man, identified as a Somali immigrant, drove a 4X4 truck loaded with gas bottles into the bustling city center of Melbourne, ignited the vehicle in a ball of flames and then attacked passers-by with a knife, police said.

He stabbed three people before being confronted by armed officers who eventually shot him in the chest. One victim died at the scene and the attacker died later in hospital.

Counter-terrorism police and intelligence officers are still piecing together how the incident occurred, but said the attacker was known to intelligence services.

Daesh later said one of its fighters carried out the knife attack, the group's Amaq news website said. It provided no evidence for the claim.

Witness footage showed police struggling for at least a minute to corral the towering man -- who was wearing a dark tunic -- as he lunged, slashed and stabbed wildly at two officers.

At least two members of the public bravely stepped in to help police. One man was armed with a cafe chair while another -- swiftly dubbed an "Aussie hero" on social media -- repeatedly tried to ram the suspect with an empty metal shopping cart.

But the attacks continued unabated before one officer opted for lethal force, shooting the suspect in the chest.

"We are now treating this as a terrorism event," said Victoria Police Chief Commissioner Graham Ashton, who said the suspect was "someone that is known" to police through family connections.

The unnamed assailant was said to reside in Melbourne's northwestern suburbs, but had come to Australia from Somalia in or around the 1990s, when the country was ravaged by a civil war.

Witness Chris Newport, 60, described how he first heard a loud noise and saw a truck on fire, rolling across the tram tracks before a second, louder bang.

"He was holding a knife and running around the place," he said of the attacker.

"Someone had a shopping trolley and was trying to stop him. Two police turned up really quickly, but there was only a couple of them. He started to go at them and there was a loud bang -- they shot him," he told AFP.

The police officers are being treated for cuts and scrapes and are not thought to be in a serious condition.

The police chief refused to give more details due to the ongoing investigation, but the authorities will face inevitable questions about how someone known to the intelligence services nonetheless managed to carry out an attack.

The counter-terrorism command has taken a lead role in the investigation and police have set up a three-block-wide exclusion zone.

Officers said they "are not looking for anyone further at this early stage" and there was no immediate evidence of an ongoing threat related to the attack.

Forensic investigators combed through the scene late Friday, where the dead victim's body lay covered in a white plastic sheet.

Melbourne is Australia's second largest city, a cosmopolitan metropolis of almost five million people famed for its cafes, bars, restaurants and high standard of living.

The attack occurred on the eve of a busy weekend in the city, with a major horse race scheduled for Saturday and a national league soccer match the following day. Sunday is also Remembrance Day, when memorial ceremonies for World War I are held.

Friday's attack is a double blow for the city as it coincides with an ongoing murder trial of 28-year-old James Gargasoulas, accused of ploughing his car into crowds in the same area in 2017, killing six people.

But the situation away from the immediate crime scene quickly returned to normal, with Melbournians enjoying a spring evening meal or a drink with friends.

Prime Minister Scott Morrison condemned the "evil and cowardly attack."

"Australians will never be intimidated by these appalling attacks and we will continue to go about our lives and enjoy the freedoms that the terrorists detest," he said in a statement.

Government sources say Australia has been the target of around a dozen terror plots in recent years. Few have been successful, sophisticated or caused mass casualties, but this latest attack is sure to fuel the already heated debate over migration.