"A man was arrested at the scene and has been taken to hospital under police guard in a critical condition", the statement said.
Police initially responded to reports of a vehicle on fire at the corner of Bourke and Swanston streets.
Major disruptions are expected in the CBD on Friday evening, as details of a major incident in Bourke Street emerge. She heard someone start screaming "he's got a knife".
The police cordoned off the area and warned people from coming near the area.
Officers said they were initially called to a vehicle fire around 4:20pm (AEDT).
The incident occurred between Swanson and Russell Streets along the pedestrian strip of Bourke Street mall around 4:20 p.m. local time, according eyewitnesses, in what has been described as a distressing scene. One of the officers shot him in the chest, Ashton said.
The bomb squad was called after the barbecue-style gas cylinders were found in the vehicle.
He died later in hospital.
Mr Ashton said the Counter-Terrorism unit is investigating and he can not give any details about the attacker's identity.
The incident is being treated as terrorism, police said.
Commissioner Ashton says Shire Ali had a criminal history for cannabis use, theft and driving offences.
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Victorian Premier Daniel Andrews said it was "distressing" day for Melbourne.
A Somalian man went on a knife rampage in central Melbourne today, stabbing three people after setting a auto full of explosives on fire.
A white sheet covered the victim as he lay on Bourke Street.
The victims' identities have not be made public, but Ashton said all three, including the deceased, are men.
"Because he was on his stomach, they turned him over to see if he's all right, he was still alive", Markel Villasin, told Australian Associated Press.
"He was breathing and he was bleeding out".
Supt Clayton told reporters that when officers got out of the auto, they were confronted by a male brandishing a knife and threatening them. Supt Clayton confirmed that when officers arrived, they were quickly cornered by the armed man as the situation escalated.
Ashton said were not looking for any other attackers, but declined to categorise the incident as a "lone wolf attack".
The counter-terrorism command has taken a lead role in the investigation.
UPDATE: The terrorist attacker has since died of his injuries.