Police said fighters, one of them in police uniform, sneaked into a gathering of hundreds of Congress Party supporters in Srinagar and opened fire in what appears to have been a suicide attack.
Intermittent firing was continuing, as members of the local police's counter-insurgency special operation group began a mopping up operation in the area, said Yusuf Jameel, Aljazeera.net's correspondent at the scene.
Several wounded police officers and civilians were being bundled into ambulances and police vehicles to remove them to hospital, he said.
The gun battle caused commotion in the nearby Sunday market where hundreds of men and women were doing shopping at the makeshift marketplace. Several people were injured in the stampede, he added.
Ghulam Nabi Azad, the state's chief minister, was to have addressed the rally but had not arrived when the gun battle erupted.
Live television footage showed marchers fleeing the area in panic as security men returned fire with automatic weapons.
Two armed Muslim groups, al-Mansoorian and Lashkar-e-Toiba, claimed responsibility for the attack in a telephone call to local news agencies.
Marchers had gathered in one of Srinagar's parks for the rally, which was to honour Rajiv Gandhi, the former Indian prime minister.
Muslim fighters had threatened to disrupt a Kashmir peace conference in the region next week that will be chaired by Manmohan Singh, the Indian prime minister.
More than 30 pro-Indian and separatist parties and groups invited were invited, but hardline separatist leader Sayid Ali Shah Jilani turned the invitation down, saying the conference was only about "hoodwinking international opinion and buying time on the core issue of Kashmir by New Delhi".
A separatist revolt against Indian rule by Muslim fighters in the disputed Kashmir region has killed thousands of people since 1989.