A police captain on the scene said that one of the gunmen detonated a suicide belt he was wearing and blew himself up as police tried to enter the church of Sayidat al-Nejat in Baghdad's Karrada neighbourhood.
The gunmen stormed the church and seized the worshippers after shooting dead two guards at the nearby Iraqi capital's stock exchange, a bishop and officials said.
The Vatican called for a swift resolution to the hostage crisis, a spokesman said.
"Helicopters are on the scene and our forces are getting ready to try to raid the church," an interior ministry official told AFP.
He said that around 40 hostages were being held inside the Sayidat al-Nejat church.
"According to my information, witnesses on the scene said there were 40 hostages," he said.
The police captain told an AFP reporter that "nine gunmen stormed the church, but one detonated his suicide belt and died when security forces tried to enter the church."
"Eight terrorists are still inside the church," he said.
The reporter heard several explosions and gunfire while helicopters hovered over the neighbourhood. Police and soldiers cordoned off the area.The Chaldean bishop of Baghdad earlier told AFP that the gunmen were demanding the release of detainees held in Iraq and Egypt and that two priests were among the hostages.
"What we know is that a number of worshippers and two priests are being held hostage at the church by terrorists," Bishop Shlimoune Wardouni said.
"They are demanding the release of terrorists held in Iraq and Egypt."Two guards at the stock exchange were killed in clashes with the gunmen trying to battle their way into the building earlier today, an interior ministry official said earlier.
"Four gunmen tried to force their way into the Baghdad stock exchange. Clashes erupted when the guards tried to stop them, and two guards were killed," the official said.
He said the attackers detonated a bomb in a car parked close wounding four civilians and escaped, fleeing to the Sayidat al-Nejat church.
The Vatican hoped the crisis would be solved quickly and peacefully."It's a very sad situation, which confirms the difficult situation in which Christians live in the country," Father Federico Lombardi told AFP.
