The hostages were seized yesterday morning after separatists had snatched the civilians in an attempt to negotiate their own surrender.
On Tuesday the Indian army fired tear gas into the house to try and flush out the separatists and secure the release of the hostages.
The hostages were released but the resistance fighters remained inside the building.
Ten people were killed and more than 60 injured on Monday in a series of grenade attacks in and around Srinigar.
Some of the heaviest injuries were inflicted when a grenade exploded in a crowded bus terminal in Srinigar.
Grenade attacks occur frequently in the Himalayan region, where separatists have been fighting Indian rule for the past 14 years.
There has been a sharp increase in the level of violence in Jammu and Kashmir over the past few weeks, with security forces trying to crack down on suspected rebels.
More than 39,500 people have died in Indian occupied Kashmir since the eruption of insurgency in the region in 1989 according to Indian figures.
However, separatists put the toll between 80,000 and 100,000.