I came across a new shop in the city today. Morris and Sons. Beautiful range of wools and silks and threads for knitting and embroidery, much, much better than anything else in the city that I know about. They also stock some craft items as well.
The website is here.
Level 1, 234 Collins Street
They also have free "stich and bitch" sessions. If you go to Contact Us > Melbourne Store and scroll down all the details are there.