A police chief has been beheaded and at least 21 people killed after Islamic State-linked militants terrorised a southern Philippines city.

More than 100 militant extremists swept through Marawi, killing civilians, soldiers and taking local priest, Father Chito Suganob and a number of people hostage.

At least 21 people have been killed since violence broke out. (AAP)

Five government soldiers and 13 militants were killed during the raid, national military spokesman Colonel Edgard Arevalo said.

Philippine President Rodrigo Duterte declared martial law yesterday in the southern region of Mindanao. The embattled zone makes up roughly one third of the country and is home to 20 million people.

"I will not hesitate to do anything and everything to protect and preserve the Filipino nation," the president said in response to the beheading of a local police chief after he was captured at a road checkpoint by ISIS militants.

Philippine President Rodrigo Duterte has declared martial law in the southern region. (AAP)

Duterte - who has been waging a controversial war on drugs that has incited violent vigilantism and claimed thousands of live – said he would consider expanding martial law across the entire country if the threat continued.

The fighting in Marawi erupted after security forces raided a house where they believed the notorious Philippine head of ISIS, Isnilon Hapilon, was hiding.

Soldier have clashes with ISIS militants in the Philippines region. (AAP)

The extremist leader of the infamous Abu Sayyaf gang is regarded by the US as one of the world's most dangerous terrorists due to his penchant for kidnapping and beheading westerners.

There is a bounty of more than $6 million for the leader’s capture.

The militants responded to the raid by burning buildings and conducting other diversionary tactics in Marawi, a mostly Muslim-populated city of 200,000 people.

Duterte said during martial law security forces could conduct searches and arrest people without warrants.

Heavy military vehicles have taken up positions throughout the embattled city. (AAP)

He also said martial law would remain until the terrorism threat had ended.