The gunbattle began when Border Security Force (BSF) troops tried to raid a house suspected to be a rebel hideout in Qamerwari, a residential area in Srinagar, summer capital of Jammu and Kashmir state, a BSF officer told Reuters.
"The militants started firing and the encounter is still going on," he added.
There has been a spate of guerrilla attacks in Indian Kashmir this week, coinciding with a visit to the disputed region by Indian Prime Minister Atal Behari Vajpayee, his deputy LK Advani, and several state chief ministers.
Vajpayee said on Friday that meaningful talks with Pakistan were not possible until there was an end to separatist violence, which New Delhi blames on Kashmiri guerrillas it says are armed and trained by Islamabad.
Pakistan says it has done all it can to stop violence and has repeatedly called for talks to resolve the decades-old dispute over Kashmir.