President Rodrigo Duterte has declared martial law in the southern third of the nation and warned he would enforce it harshly.
The violence erupted on Tuesday night after the army raided the hideout of Isnilon Hapilon, an Abu Sayyaf commander who is on Washington's list of most-wanted terrorists.
The militants called for reinforcements from an allied group, the Maute, and some 50 gunmen managed to enter the city of Marawi.
"We are in a state of emergency," Mr Duterte said after landing in Manila from a visit to Moscow, adding that skirmishes were continuing.
"I have a serious problem in Mindanao and the Isis footprints are everywhere."
He said he may declare martial law elsewhere in the Philippines if militants expand their attacks.
Archbishop Socrates Villegas, president of the Catholic Bishops Conference of the Philippines, and Marawi Bishop Edwin de la Pena said the militants forced their way into the Marawi Cathedral and seized a priest, 10 worshippers and three church workers.
The priest, Father Chito, and the others had no role in the conflict, Mr Villegas said.
"He was not a combatant. He was not bearing arms. He was a threat to none," Mr Villegas said of Mr Chito.
"His capture and that of his companions violates every norm of civilized conflict."
Mr Villegas says the gunmen are demanding the government recall its forces.
President Duterte declared martial rule for 60 days in the entire Mindanao region, the restive southern third of the Philippine archipelago.
He had vowed to be "harsh".
"I warned everybody not to force my hand into it," President Duterte said on a plane en route to the Philippines.
"I have to do it to preserve the republic."
Martial law allows Mr Duterte to harness the armed forces to carry out arrests, searches and detentions more rapidly.
He has repeatedly threatened to place the south, the scene of decades-long Muslim separatist uprisings, under martial law.
But human rights groups have expressed fears that martial law powers could further embolden Mr Duterte, whom they have accused of allowing extra-judicial killings of thousands of drug suspects in a crackdown on illegal drugs.
Details from inside Marawi were sketchy because the largely Muslim city of more than 200,000 people appeared to be largely sealed off and without electricity.
"The whole of Marawi city is blacked out, there is no light, and there are Maute snipers all around," Defence Secretary Delfin Lorenzana said late on Tuesday in Moscow, where he was accompanying Mr Duterte on an official trip.
President Duterte cut the trip short and headed back to the Philippines.
Mr Lorenzana said dozens of gunmen occupied city hall, a hospital and a jail and burned a Catholic church, a college and some houses in an assault that killed at least two soldiers and a police officer and wounded 12 others.
Hapilon, an Arabic-speaking Islamic preacher known for his expertise on commando assaults, pledged allegiance to the Islamic State group in 2014.
He is a commander of the Abu Sayyaf militant group and was wounded by a military airstrike in January.
Troops sealed off major entry and exit points to prevent Hapilon from escaping, military chief of staff Gen Eduardo Ano told The Associated Press by telephone late on Tuesday from Moscow, where he was accompanying Mr Duterte.
"We will conduct house-to-house clearing and do everything to remove the threat there. We can do that easily," Gen Ano said, but added it was more difficult in an urban setting because of the need to avoid civilian casualties.
He said the group erected Islamic State flags at several locations.
President Duterte met late on Tuesday with Russian President Vladimir Putin and said he is counting on Russia to supply weapons for the Philippines to fight terrorism.
"Of course, our country needs modern weapons, we had orders in the United States, but now the situation there is not very smooth and in order to fight the Islamic State, with their units and factions, we need modern weapons," he said, according to Russian state news agency Tass.
While pursuing peace talks with two large Muslim rebel groups in the south of this predominantly Roman Catholic nation, Mr Duterte has ordered the military to destroy smaller extremist groups which have tried to align with the Islamic State group.
The Maute group is one of less than a dozen new armed Muslim groups that have pledged allegiance to the Islamic State and formed a loose alliance with Hapilon reportedly designated as the alliance's leader.
The Maute has been blamed for a bombing that killed 15 people in southern Davao city, Mr Duterte's home town, last September and a number of attacks on government forces in Lanao, although it has faced setbacks from a series of military offensives.
Last month, troops backed by airstrikes killed dozens of Maute militants and captured their jungle camp near Lanao del Sur's Piagapo town.
Troops found homemade bombs, grenades, combat uniforms and passports of suspected Indonesian militants in the camp, the military said. - AP
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