The raid in the Bhojpur district, 500km east of Kathmandu, resulted in the deaths of at least 21 government troops.
Police confirmed that communication links in the area have been cut off.
State-run radio said the body of one rebel had been found
after the fighting went on through the night.
One army officer told journalists the Tuesday night attack was the biggest since peace talks collapsed last August.
Fearing punishment or even a revenge attack, terrified Nepalese in the south of the kingdom fled leaving a policeman stabbed by Maoists to die.
The security official was abducted from Bara district on Tuesday and stabbed repeatedly. Despite taking hours to die, no one came forward to help him.
One police official said: "He writhed in pain and requested water for six hours but no one dared to help him, fearing reprisals from the Maoists."
Human rights groups have accused the rebels, who have been battling since 1996 to install a communist republic, of terrorising local people and committing various atrocities.
But they have also accused soldiers fighting the insurgents of human rights atrocities too.
More than 8900 people have been killed in the communist rebels' revolt against the monarchy since 1996.