BRAD THOMPSON of Nelson Bay was woken in the early hours of yesterday by screams coming from the house next door.

He ran from his Austral Street duplex into the chill night air and into a chaotic scene of grief and anguish.

Mr Thompson's neighbours, Julie Gibson and Neil Tarrant, had escaped their two-storey weatherboard home after it caught fireabout 1.30am.

Police believe the fire started at the rear of thehouse and the flames spread quickly through the building.

The adults rounded up the five children inside and escaped through the front door. But in the confusion, one of the children, Taya, became lost in the smoke and was trapped inside as the flames engulfed the house.

"They were sitting up on the road and they were just screaming, 'There's a two-year-old inside,' " Mr Thompson said. He went to his neighbour, who had been running in and out of the burning house.

"She said that she had her there and was trying to get the other kids out as well and just somehow lost her in the panic with the other kids," he said.

"She went back to get her out and could hear her inside, but she just couldn't get in."

A NSW Fire Brigades spokesman, Chris Jurgeit, said firefighters had recovered Taya's body.

"Every firefighter wants to save everyone. It's just so tragic," he said.

Ms Gibson suffered smoke inhalation and minor burns across her face, hands and head as she tried to rescue her granddaughter.

Mr Tarrant, who was recovering from his latest dose of chemotherapy for an advanced case of throat cancer, also suffered smoke inhalation.

He underwent emergency surgery yesterday afternoon and doctors were still treating him last night.

The other family members were treated at a Nelson Bay clinic for smoke inhalation and shock and were being looked after by Hunter New England Health staff last night.