An Indian soldier and a Muslim civilian were killed during a battle between troops and Islamic rebels on Thursday morning.
The soldier was killed when independence fighters ambushed an army patrol, firing AK rifles and tossing grenades in the village of Lamdoora, near Srinagar.
"The ambush left a soldier dead and prompted soldiers to return the fire," a police spokesman said. A civilian was killed in the ensuing crossfire, he added.
Police said the troops immediately sealed off the village and launched house-to-house searches to find the rebels.
Men were ordered out of their homes to parade in front of masked informers - a routine exercise to try and segregate independence fighters from civilians.
The area is a stronghold of the region's dominant rebel group Hizb al-Mujahedin which is fighting to secede Kashmir from India and join it with neighbouring Pakistan.
Indian soldier killed
In a separate incident, an Indian soldier was killed on Thursday morning in an exchange of artillery and mortar fire with Pakistani troops along their de facto border in Kargil district.
"A soldier was killed when Pakistani troops pounded frontier Drass sector with artillery and mortars," an Indian police source said.
He said Indian troops retaliated, but it was not known if there were casualties on the other side of the Line of Control - the de facto border that divides Kashmir between bitter rivals, India and Pakistan.
Pakistan and India have fought
two wars over Kashmir
"The fighting was heavy and sparked fear among the residents living in the villages along the LoC," the source said.
Indian and Pakistani troops routinely exchange fire along the LoC.
On Sunday, 12 people were killed in Pakistan-administered Kashmir during such exchanges, according to Islamabad.
Pakistani President, Pervez Musharraf, last month proposed a ceasefire to India along the LoC, but it was rejected by New Delhi as a "propaganda".
India and Pakistan have fought two of their three wars over Kashmir, which is divided between them and claimed in full by both.
New Delhi accuses Islamabad of arming and funding an anti-Indian insurgency in Kashmir that has claimed more than 39,500 lives since 1989 by official count.
Separatists put the toll between 80,000 and 100,000.
Pakistan denies the Indian charge, but says it renders moral and political support to the "just cause" of Kashmiris for self-determination.