Authorities believe militant leader Isnilon Hapilon, who is on Washington's most wanted list, is still in hiding in Marawi, a city of 200,000 on Mindanao island, 830 kilometres south of Manila, where fighting has raged since Tuesday.

Attack helicopters fired rockets into buildings where heavily-armed militants were holed up threatening to kill hostages, including local priest Father Chito Suganob and at least 10 parishioners.

By Friday morning at least 40 militants were believed to still be in the city.

Witnesses said troops hid behind walls and armoured vehicles exchanging volleys of fire with militants from the little known but extremely violent Maute group, one of about 10 groups in the southern Philippines that have sworn allegiance to Islamic State.

Thousands of resident have fled the city and most streets were eerily empty.

Troops were helping to extract residents who had been too afraid to leave their homes.

The Philippine military was surprised by the strength of the militants, who numbered more than 100 and were armed with high-powered weapons.

A local police chief was beheaded.

Marawi is a predominantly Muslim city in the Catholic-majority nation of 100 million.

The violence has intensified fears that Islamist extremists could gain a foothold across the southern Philippines.

Foreign Minister Julie Bishop has warned of the possibility of Islamic State declaring a "caliphate" there as extremists are forced out of the Middle East.

"This brings the threat right to our doorstep," she said in March.

Hapilon, an Arabic-speaking preacher expert in ground assaults, is a commander of the Abu Sayyaf group that is notorious for carrying out beheadings, bombings and kidnappings-for-ransom.

The violence broke out on Tuesday when Philippine security forces botched an attempt to capture Hapilon, who has a $US5 million bounty on his head, and the militants called in dozens of fighters from bases in remote areas.

Militants roamed the city brandishing black Islamic State flags as they torched a church and key government buildings and two jails.

More than 100 prisoners were set free.

Philippine President Rodrigo Duterte has declared martial law across Mindanao, the country's second-largest island that is home to 20 million people, and threatened to expand it to other provinces to combat terrorism.

Defence Secretary Delfin Lorenzana said that under the law the military will have "control of movement, searches and the arrest of detained people and suspension of writ of habeas corpus".

Human rights advocates and some politicians have warned the declaration could lead to more abuses in the country where Mr Duterte's so-called war on drugs has left almost 8000 people dead since he took office in June last year.

Martial law is a sensitive issue in the Philippines. Under the late dictator Ferdinand Marcos security forces carried out massive arbitrary arrests, detention, torture and extra-judicial killings. Marcos was forced into exile by a 1986 "people power" revolution.

Declaring martial law as he cut short a trip to Moscow to return to Manila, Mr Duterte told reporters "it will not be any different from what the president Marcos did. I'd be harsh."

The Catholic Church has lashed out at the militants for kidnapping Father Suganob.

"He was not a combatant. He was not bearing arms. He was a threat to none," said Archbishop Socrates Villegas, president of the Catholic Bishops' Conference of the Philippines.

Militants have telephoned church officials and threatened to kill Father Suganob and the other hostages unless troops back off.

Prayer sessions for the hostages have been held across the country.