Claiming responsibility for the attack via its Amaq news agency, the militant group said the attack was in retaliation for Australia's involvement in the US-led coalition fighting the militants in Iraq and Syria.
Armed police shot a gunman dead after a two-hour hostage situation and successfully rescued a woman in her 20s who was being held against her will.
The ordeal started around 4pm Monday, when police attended reports of an explosion at the Buckingham Services Apartments in Bay Street, and found a body in the foyer of the building.
"This terrorist attack by a known criminal, a man who was only recently released on parole, is a shocking, cowardly crime", he said. The woman was later freed and unharmed, according to the Herald.
"He has a long criminal history with us, but also from what we're piecing together comments he made related to Islamic State and Al-Qaeda certainly for us put this in the terrorism category", he said, adding that, Khayre was released on parole in November a year ago.
A 36-year-old woman from Ripponlea sustained minor injuries after she was held hostage in the ground floor apartment.
Hours after the fatal shootout, the IS claimed responsibility for the attack.
"How was this man on parole?"
The authorities labelled the attack as a terrorism incident but added that investigations are ongoing into whether it was planned or random.
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But instead he left the apartment and began shooting at police.
Seven news director Simon Pristel said when they asked for more information from the caller, he hung up.
The woman escaped safely but three officers were injured as police stormed the building to end the hostage situation.
Islamic State has claimed responsibility for Monday's incident, but Comm Ashton downplayed their statement.
Channel Seven reported that a man claiming to be the hostage-taker called its newsroom during the incident and said: "This is for IS, this is for al-Qaeda".
Victoria Police says hundreds of its officers, as well as federal police, are "making sure everything that's behind this" is going towards finding his motivation.
Police are investigating whether Khayre deliberately lured officers into a deadly ambush after it was revealed he booked a female escort, whom he took hostage, and sparked an alert on his tracker.
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