South Korea says it has returned fire after North Korea fired dozens of artillery shells at one of its border islands, killing two marines.
The South's military was placed on its highest non-wartime alert after the shells landed on Yeonpyeong island.
The North said it did not fire first in the incident. Two South Korean marines and four civilians were also injured.
Analysts say this is one of the most serious clashes since the Korean War ended without a peace treaty in 1953.
There have been occasional cross-border clashes since, but the latest incident comes at a time of rising regional tension.
North Korea's reclusive leader Kim Jong-il is thought to be ill and trying to ensure the succession of his youngest son.
On Saturday, North Korea also showed off what it claimed was a new uranium enrichment facility - potentially giving it a second route to a nuclear weapon.
The move prompted the US special representative for North Korea, Stephen Bosworth, to rule out the resumption of six-party talks on nuclear disarmament that Pyongyang abandoned two years ago.
'Unpardonable'A spokesman for South Korea's Joint Chiefs of Staff said North Korean shells had started falling in the waters off the island of Yeonpyeong at 1434 local time(0534 GMT).
At least 50 landed directly on the island, most hitting a South Korean military base there.
The South's military immediately fired back some 80 shells in self-defence, Col Lee Bung-woo added.
A resident on the island told the AFP news agency that dozens of houses were damaged by the barrage, while television pictures showed plumes of smoke rising above the island.
"Houses and mountains are on fire and people are evacuating. You can't see very well because of plumes of smoke," a witness on the island told YTN television station. "People are frightened to death."
Local government spokesman Yoon Kwan-seok said the shelling lasted for about an hour and then stopped abruptly.
"The whole of Yeonpyeong island was blacked out following the North Korean attacks," he was quoted as saying by the Yonhap news agency. "All of the island's 1,600-odd residents were evacuated to a shelter."
The South Korean military has also deployed fighter jets to Yeonpyeong, which lies about 3km (1.8 miles) south of the disputed inter-Korean maritime border and 100km (60 miles) west of the Korean Peninsula.
Later, South Korean President Lee Myung-bak warned North Korea that his country would "sternly retaliate against any further provocations".
"North Korea's shelling of Yeonpyeong island constitutes a clear armed provocation. Furthermore, its reckless shelling of civilian targets is unpardonable," his office said in a statement. "North Korean authorities must take responsibility."
But North Korea's supreme military command blamed South Korea for the incident.
"Despite our repeated warnings, South Korea fired dozens of shells from 1300... (0400 GMT) and we took strong military action immediately," the state-run Korean Central News Agency quoted it as saying.
The military also threatened to "launch merciless military retaliatory strikes" if its border was violated by "even 0.001mm".
It did not say whether North Korea had suffered any casualties or damage.
A spokesman for the Chinese foreign ministry said that both countries should "do more to contribute to peace".
"What's imperative now is to restart six-party talks as soon as possible," Hong Lei told a news conference in Beijing.
Japan's Prime Minister, Naoto Kan, said he had ordered ministers to prepare for any eventuality.
"I ordered them to make preparations so that we can react firmly, should any unexpected event occur," he said after an emergency cabinet meeting in Tokyo. "I ordered them to do their utmost to gather information."
The White House strongly condemned the attack and called on North Korea to halt its "belligerent action".
Many residents of Yeonpyeong fled the island by ferry after the bombardmentThe BBC's John Sudworth in Seoul says news of the incident has rattled international financial markets, with both the Korean won and Japanese yen falling.
The Bank of Korea said it would hold an emergency meeting to assess the possible market impact.
This western maritime border, also known as the Northern Limit Line, has been the scene of numerous clashes in the past.
In March, a South Korean warship went down near the border with the loss of 46 lives. International investigators say a North Korean torpedo sank the ship, although Pyongyang has denied any role in the incident.
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