Pakistani troops killed two Indian soldiers on Tuesday near the tense disputed border between the nuclear-armed neighbours in Kashmir and one of the bodies was badly mutilated, the Indian army said.

The firefight broke out at about noon on Tuesday (0630 GMT) after an Indian patrol moving in foggy conditions discovered Pakistani troops about half a kilometre (1,600 feet) inside Indian territory, an army spokesman told AFP.

A ceasefire has been in place along the Line of Control that divides the countries since 2003, but it is periodically violated by both sides and Pakistan said Indian troops killed a Pakistani soldier on Sunday.

"The government of India considers the incident as a provocative action and we condemn it," said a statement from India's defence ministry over the latest clash. "The government will take up the incident with the Pakistan government."

Relations between the neighbours had been slowly improving over the last few years following a rupture in their slow-moving peace process after the 2008 attacks on Mumbai, which were blamed by India on Pakistan-based militants.

"There was a firefight with Pakistani troops," army spokesman Rajesh Kalia told AFP from the mountainous Himalayan region, confirming the names of the men as sergeants Hemraj Singh and Sudhakar Singh.

"We lost two soldiers and one of them has been badly mutilated," he added, declining to give more details on the injuries.

"The intruders were regular (Pakistani) soldiers and they were 400-500 metres (1,300-1,600 feet) inside our territory," he said of the clash in Mendhar sector, 173 kilometres (107 miles) west by road from the city of Jammu.

Indian reports and a military source speaking to AFP indicated that the mutilated soldier may have been decapitated, but further investigations and a post-mortum were required to confirm this.

In Islamabad, a Pakistan military spokesman denied what he called an "Indian allegation of unprovoked firing", adding that the Indian account was "propaganda to divert the attention of the world from Sunday's raid on a Pakistani post".

Pakistan's army says Indian troops crossed the Line of Control on Sunday and stormed a military post in an attack that left one Pakistani soldier dead and another injured.

It lodged a formal protest with India on Monday.

India denied crossing the line, but a foreign ministry spokesman said Indian troops had undertaken "controlled retaliation" on Sunday after "unprovoked firing" which damaged a civilian home.

The deaths deal a serious blow to efforts to ease tension in South Asia and improve diplomatic relations. Steps such as opening up trade and offering more lenient visa regimes have been a feature of recent high-level talks.

Muslim-majority Kashmir is a Himalayan region that India and Pakistan both claim in full but rule in part. It was the cause of two of three wars between the neighbours since independence from Britain in 1947.

The chief minister of the Indian state of Jammu and Kashmir, Omar Abdullah, condemned the alleged mutilation as "unacceptable in any civilised society".

"Clearly someone up the chain of command (in Pakistan) wants to do everything to derail any dialogue between the two countries," he wrote on Twitter.

The last major escalation in Kashmir occured in 1999 in fighting that claimed more than 1,000 combatants on both sides after India accused Pakistani militants and troops of occupying strategic Indian peaks.

The disputed death of Indian soldier Saurabh Kalia, who was allegedly tortured after being captured during the Kargil fighting, remains an emotive issue in India 14 years after the clash.

India's cable news channels widely reported the latest deaths and alleged mutilation under headlines reading "Pak's Open Aggression", "Pakistan's Barbarism", and "Kargil-type stunt".

The last major mobilisation of Indian troops to its border with Pakistan took place in 2001 after an attack on the national parliament in New Delhi by five Islamic militants.