Anti-terror chief Francois Molins said the suspect, named as Mohammed Merah, 23, of Algerian descent, intended to kill a soldier and two police officers.
Merah, who says he was trained by al-Qaeda, is suspected of murdering three soldiers and four Jewish people.
Police have surrounded his flat and are trying to persuade him to surrender. He is said to be heavily armed.
Earlier reports said he had been captured, but officials later rebuffed the claims.
At the sceneJust after President Sarkozy arrived in Toulouse for meetings at a military barracks close to where the siege is taking place, reports began circulating that it was all over, Mohammed Merah had been arrested.
But minutes later came the denials. First by local officials in Toulouse, then by the interior minister himself. It all added to the tension. How will the siege which began at 3am local time on Wednesday morning, be brought to an end?
Officially the French government says it wants to capture him alive so that he can stand trial on charges of murdering seven people and injuring at least two others.
But it will not be an easy operation if he decides to stand and fight. He is reported to have an automatic rifle, a sub machinegun and grenades inside his apartment.
On 11 March, a soldier was shot and killed while waiting to see a man about selling his motorcycle.
Days later, two soldiers were shot and killed, and a third was wounded while waiting at a cash machine.
Then earlier this week, three children and an adult were shot and killed outside a Jewish school.
The four Jewish victims were buried in an emotional funeral in Jerusalem earlier.
In a news conference, Mr Molins said Merah had planned to kill a soldier later on Wednesday and also had plans to target the police.
"If he's telling the truth, he would have left his house this morning and he would have once again killed any soldier that he came across," the prosecutor said.
Mr Molins said the suspect had expressed no regret for the killings, but had said he wanted to kill more people and "bring France to its knees".
President Nicolas Sarkozy has attended a memorial at a military base in nearby Montauban for the three murdered soldiers.
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Police moved into Merah's block after two officers were shot at when they tried to get into his flat.
Officials say he is heavily armed with a Kalashnikov high-velocity rifle, a mini-Uzi 9mm machine pistol, several handguns and possibly grenades.
- French citizen of Algerian extraction, aged 23
- Has criminal record in France for non-terrorist crimes
- Has described himself as an al-Qaeda member and has spent time in Afghanistan and Pakistan
Hundreds of officers are now stationed outside the block.
Elsewhere in the city, police are hunting for accomplices and have detained several members of his family.
His mother was taken to the scene in the hope that she could persuade him to surrender, but she told police that she had no influence over her son.
Negotiators have been talking to Merah all morning, but officials said he appeared to have no particular demands.
The suspect has said he acted to "avenge Palestinian children" and said he would give himself up.
Merah claimed to have received al-Qaeda training in Pakistan's Waziristan area, and also said he had been to Afghanistan, prosecutors said.
Afghan officials told the BBC he had been jailed in Kandahar for planting bombs in 2007, but escaped in a Taliban-led break-out in 2008.
Other Afghan sources cast doubt on the claims, saying the man jailed in Kandahar might have been a different person with the same name.
Mr Molins said Merah had visited Afghanistan twice.
He gave no details of the first visit, but said that during his second trip last year, Merah was captured by Afghan forces and handed to the Americans, who put him on a plane back to France.
But American officials told CNN that US forces had not dealt with Merah, and that the Afghans had handed him to French forces, who had returned him to France.