If you are using Availability Zones then you are automatically using different fault and update domains as you are actually hosting your VMs across multiple datacentres so naturally these VMs cannot be on the same physical hosts. Therefore these two options are mutually exclusive, you can choose one or the other with availability zones being the more resilient option as this not only spreads your VMs across fault and updates domains but also across different datacentres.
In your example you should deploy your 3 VMs across three separate availability zones for best resiliency otherwise if you deploy to an availability set they will all be in the same datacentre but on separate fault/update domains.
You also get a higher SLA on Azure VMs based on which option you choose.