Footage taken by witnesses showed the man lunging with a large knife at police, who shot him in the chest and killed him. Bystanders were yelling at police: "Just shoot him, just shoot him".

Police said Shire Ali's Australian passport was cancelled in 2015 after an intelligence report he planned to travel to Syria, but an assessment was made that whilst he had radical views, he posed no threat to national security.

"I think it is fair to say he (Shire Ali) was inspired. He was radicalised," Australian Federal Police Acting Deputy Commissioner Ian McCartney told reporters in Melbourne.

"We're not saying there was direct contact. We're saying it was more from an inspiration perspective."

Australian counter-terrorism investigators were searching two properties in suburban Melbourne on Saturday morning.

"Joint Counter Terrorism Team investigators are executing search warrants at two addresses in Werribee and Meadows Heights this morning" Victoria police said in a statement. "More information will be provided when it's appropriate to do so."

Scott Morrison, the Australian Prime Minister, said the national terrorism advisory remained at "probable", the midpoint of a five-tier system, and told reporters in Sydney that radical Islam was the issue.

"I need to call it out. Radical, violent, extremist Islam that opposes our very way of life. I am the first to protect religious freedom in this country, but that also means I must be the first to call out religious extremism," he said.

Isil’s propaganda channel said the group was behind the attack.

"The perpetrator of the operation... in Melbourne... was an Islamic State fighter and carried out the operation... to target nationals of the coalition" fighting Isil, Amaq reported a jihadist security source as saying.