Soldiers shot dead Ghulam Rasul Dar alias Gazi Nasir-u-din, a senior commander of the Hizb al-Mujahidin and four others in a clash at Zainakote, on the edge of the summer capital Srinagar, an army spokesman said.
Dar, 47, was the group's leading commander in Kashmir after Pakistan-based supremo Sayed Salah ad-Din.
He had been active in the region for the past 14 years, constantly evading the security forces who placed him at the top of their list of "most wanted militants".
"Dar was killed along with Hizb al-Mujahidin's financial chief Fayaz Ahmad during a 30-minute long encounter," the spokesman said.
Indian army Brigadier A K Chaudhary described the killing as "a spectacular achievement".
Chaudhary, who heads Ten Rashtriya (National) Rifles - a counter insurgency wing of the Indian army - said his men had information about the presence of Dar and his close aide Fayaz Ahmad in a house on the outskirts of the summer capital Srinagar.
He said his men had ringed a house where the two were present and asked them to surrender. "Instead of giving up they fired at my men, who returned the fire killing both of them," he said.
Ahmad was identified as Hizbul's financial and publicity chief.
A prominent English daily newspaper, the Excelsior, claimed on Saturday however that the two were arrested by the security forces with the help of federal intelligence agencies and later killed in a "fake encounter."
File picture of Dar (L) announcing
a ceasefire in July 2000
"Field sleuths of the (intelligence) agencies and the communication equipment used by the militants are believed to have played a key role in arresting them," the newspaper said, quoting "extremely reliable sources in the state administration."
Security officials denied the allegations.
Dar, 47, had been a member of the political group Jamaat-e-Islami but joined Hizb al-Mujahidin in 1990, serving as district, divisional and later chief commander of operations.
Intelligence officers believe Dar had recruited hundreds of
Kashmiri youth for Hizbul and established hideouts throughout the rugged Himalayan region.
On the diplomatic front a top Kashmiri separatist, one of five due to hold the first high-level talks with India next week, said on Saturday the United States was facilitating the current peace process between India and Pakistan.
"Washington is making a sincere effort to improve relations between India and Pakistan and promote peace in the region," Umar Faruq, chief priest at Kashmir's main mosque, said.
Faruq claimed that during his recent trip to New Delhi he met a US delegation which showed him a report on how Washington was facilitating talks between the two nuclear rivals
During a regional summit in Pakistan earlier this week Indian and Pakistani leaders agreed to hold composite dialogue on all pending issues, including Kashmir, next month.
Faruq claimed that during his recent trip to New Delhi he met a US delegation which showed him a report on how Washington was facilitating talks between the two nuclear rivals.
"The process is moving forward on the same lines," he said, adding that the delegation had given the assurance that the "wishes and aspirations" of the Kashmiri people would not be ignored.