Twin explosions followed by heavy gunfire were heard from the upmarket Central Hotel, close to the presidential palace, with the Islamist gunmen reportedly blasting their way into the fortified building before storming the complex.
The attack is one of the worst in recent years.
An official at the presidential palace, known as Villa Somalia, said that at least 25 people were killed and the severity of injuries among the wounded meant the death toll was expected to rise.
The hotel attack began with two explosions caused by a car bomb and a suicide bomber followed by gunmen who charged the building, with heavy gunfire heards as security forces took back control.
"The building was badly hit, the explosion was very big," said police officer Abulrahman Ali.
"There were very many wounded people too, many of them seriously."
Thick clouds of black smoke were seen pouring from the hotel as the injured were rushed to hospital.
Shebab militants claimed responsibility for the attack.
"Our fighters attacked the Central Hotel," Shebab spokesman Abdulaziz Abu Musab told AFP. "The aim is to kill the apostate officials."
Shebab rebels have staged a string of assaults in their fight to overthrow the country's internationally-backed government. They have targeted hotels, the international airport, Villa Somalia, a United Nations compound and restaurants.
The extremists say they are targeting government officials for permitting the deployment of foreign African Union troops on Somali soil.
Today's attack comes a month after a Shebab suicide bomber exploded a car at the nearby SYL hotel, the day before a planned visit by Turkey's president.
United Nations envoy to Somalia Nick Kay condemned the "brutal terrorist attack" on the hotel.
"My heart goes out to those who have suffered. We stand firm with the Somalia people," he said in a statement.
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