Twenty guns and two homemade explosives were recovered, the source said.
The deadly firefight in Guerrero came one day after 12 federal police officers were killed in an ambush in the neighbouring state of Michoacan, a stronghold of drug activity. It was unclear if the two shootouts were related.
Cartel turf battles
Taxco, popular with foreign visitors because of its colonial architecture and more than 2,000 silver shops, has increasingly been the scene of cartel turf battles.
Two weeks ago, authorities discovered 55 bodies in an abandoned silver mine in the town that was being used as a dumping ground for apparent victims of drug violence.
Tuesday's clash took place just hours after armed men killed three federal officers in the northern city of Chihuahua, and inmates at a prison in northern Sinaloa state used guns apparently smuggled inside to kill 21 prisoners.
At least eight more inmates were later stabbed to death.
The dozens of deaths on Monday and Tuesday followed a particularly bloody pair of weeks.
Last week, assailants killed 16 people in one day in the northern city of Ciudad Madero, and attackers burst into a drug rehab centre in Chihuahua and shot 19 men to death.
In a televised message on Tuesday night, Felipe Calderon, the Mexican president, asked people to support the fight against organised crime and urged them to report criminals to authorities.
"I say this is a fight of all Mexicans, because criminals don't discriminate and hurt all of society," he said as a telephone number for anonymous tips flashed on the screen.
"The information that you can give us is key in helping us advance in this fight.
"This is a battle that is worth fighting because our future is at stake.
"It is a battle that, with all Mexicans united, we will win."
Calderon's speech came as his government announced some of its toughest restrictions ever on dollar cash transactions to fight money laundering that fuels drug traffickers.
Tourists and Mexicans without bank accounts will be limited to exchanging a maximum of $1,500 for pesos each month under the new rules, Ernesto Cordero, the country's finance secretary, said.
The measure is meant to help stem the flood of cash flows possibly linked to drug trafficking.
In recent years, banks have seen an excess of about $10bn in dollar deposits and transactions that cannot be explained by normal business activity, he said.
The influx of suspect US dollars has also apparently contaminated legitimate Mexican businesses, according to the banking industry.
“The problem is in the formal, legal economy, where we have seen an unusual increase in transactions carried out in dollars,” Luis Robles, vice-president of the Mexican Association of Banks, said.