The armed militants forced their way into the hotel on Wednesday, killing a policeman in their first attack in a year in Kashmir's summer capital. A second man died of injuries in hospital and nine people have been injured. Jamait-ul-Mujahideen, an Islamist militant group which wants Kashmir to be merged with Pakistan, claimed responsibility for the attack and vowed to inflict heavy damage on security forces.
The militants, no more than three in number, were believed to be moving from room to room inside the small hotel, firing intermittently to keep soldiers at bay, Prabhakar Singh, a senior security officer, told Reuters.
Police said the hotel was now empty.
"We have rescued 400 people from nearby buildings and the hotel as we cannot launch a bigger operation without evacuating the area completely," Singh said.
Kashmir is the core dispute between Pakistan and India and the cause of two of their three wars since their independence from British rule in 1947.
After a period of relative calm, militants have stepped up attacks across India-controlled Kashmir region, where officials say tens of thousands have been killed since 1989.
But Pakistan's portion of divided Kashmir, long free of Islamist militant violence, has seen several attacks over the past year. A suicide bomber killed three soldiers at a military school in Pakistani Kashmir on Wednesday.