A man has been arrested over Wednesday night's fatal squatters fire in Melbourne's inner west.

The bodies of three people were found after a blaze at a former Kinnears factory on Ballarat Road in Footscray at 11:30pm.

A 52-year-old man was arrested in Melbourne's CBD late yesterday afternoon.

He is currently in custody and being questioned by detectives from the Arson and Explosives Squad.

The three bodies found inside the factory are yet to be identified, but police believe the victims were two men and a woman.

The bodies of three people were found inside a room at the rear of the factory. ( AAP: Tracey Nearmy )

Earlier yesterday Detective Senior Sergeant Brad Nichols said police did not yet know what started the blaze but it was being treated as suspicious.

"We have spoken to a number of neighbours and we are still collecting more information and we're trying to find more witnesses," he said.

Squatters have been living in the factory for more than a year, residents said.

The building is owned by developers with plans to build apartments.

'Screams' heard as residents tried to douse flames

The factory is near Footscray City College, a secondary school, and the principal and police had previously tried to move the squatters on.

Ari Mangidi lives behind the factory and said several neighbours tried desperately to put the fire out.

"They [brought] water with just a small bucket. I think anything they had to bring water [in], they [brought]," he said.

"And then they tried to throw the water inside but it didn't [help] because the fire was already too big."

Taxi driver Mohamed Ali was passing by and saw the fire and heard screams when he got to the scene.

"When I passed the street I saw the fire over there. When I was turning I heard some screaming but I was not sure who was screaming," he said.

Spotlight on Melbourne's homelessness crisis

Locals told the ABC that homelessness was an issue in the Footscray area, and a separate camp had been set up at nearby Quarry Park.

Homelessness is an increasingly contentious issue in Melbourne, with growing numbers of rough sleepers.

Last month, police cleared a large camp set up along Flinders Street Station in central Melbourne, forcing many homeless people to relocate to other parts of the city.

More than 33,000 Victorians are on the waiting list for public housing.