India delivered a dressing-down Wednesday to Islamabad's envoy to Delhi as it accused Pakistan's army of beheading one of two soldiers killed in Kashmir, but both sides warned against inflaming tensions.

While Pakistan insisted no such incident had taken place and suggested a UN inquiry be held, India denounced the "inhuman" treatment of the pair who were killed two days after a Pakistani soldier was also slain in the Kashmir region.

As India's government mulled over its response, Foreign Minister Salman Khurshid struck a note of caution and warned against exacerbating the situation.

Khurshid said Pakistan's ambassador Salman Bashir had been "spoken to in very strong terms" after he was summoned for an angry rebuke over the killings.

But in a subsequent press conference, Khurshid said that "whatever has happened, should not be escalated".

"We cannot and must not allow for an escalation of a very unwholesome event that has taken place," he added.

The two Indian soldiers died after a firefight erupted in disputed Kashmir on Tuesday. The Indian army said a patrol moving in fog discovered Pakistani troops about 500 metres (yards) inside Indian territory.

"We can confirm that one of the Indian soldiers was beheaded by the Pakistani army," spokesman Jagdeep Dahiya told AFP. "It was a dastardly act as they have taken away the head."

Senior military officers who visited the site of the attack said an attempt had also been made to remove the head of the second soldier.

"There was a slash on the neck of the second body," one officer said in New Delhi on the condition he is not identified by rank or name.

In a sign of a desire for revenge among troops on the ground, the officer said it was "now a matter of prestige, the battalion has to regain its honour".

Defence Minister A.K. Antony said the Pakistan army was guilty of "inhuman" behaviour in the treatment of the bodies while newspaper headlines stoked the tensions, with the Mail Today denouncing "Pak Army Butchers".

But amid the chorus of condemnation, Pakistan's Foreign Minister Hina Rabbani Khar appeared on Indian television to issue a firm denial and criticise the statements by authorities in Delhi.

"Let me just say that we are a bit appalled at some statements that are coming in from India because the government of Pakistan has absolutely rejected that any such incident took place," she told India's CNN-IBN network.

"It is not Pakistan's policy to not observe the ceasefire on LoC," she added in reference to a de facto border in Kashmir known as the Line of Control.

Khar said Pakistan tempered its language after the death of one of its soldiers on Sunday in a border skirmish and India should have followed suit.

"We believe that these issues must be dealt with in a responsible manner," she said.

"We can ask a third party to do investigation on this, you know that UN military observers exist, we can call them.

"It is not Pakistan's policy to do tit-for-tat... We must not all go back to having a go at each other."

Khurshid has suggested the attack was designed to "derail" an already fragile peace process between the nuclear-armed neighbours which have previously fought three wars.

Some analysts have suggested that militants could have been involved.

Asked who was responsible for killing the Indian soldiers, Pakistani political analyst Hasan Askari told AFP: "It's very difficult to suggest. It could be militants, it could be the Pakistan army. Indians are talking of a lot of brutality on the dead bodies - if that is true then perhaps the probability of militants is quite high."

Relations between political leaders of both countries had been slowly improving following a rupture after the 2008 attacks on Mumbai, which India blamed on Pakistan-based militants.

Steps such as opening up trade and offering more lenient visa regimes have been a feature of recent high-level talks.

Observers said a freeze on high-level dialogue would be among the options for the Indian government.

The clash took place in Mendhar sector, 173 kilometres (107 miles) west of the city of Jammu, the winter capital of the state.

Army sources said there had been further exchanges along the de facto border on Tuesday night which caused no damage and the border was calm on Wednesday.

A ceasefire has been in place since 2003 along the LoC, but it is periodically violated by both sides.

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 their three wars since independence from Britain in 1947.