The chief of Jaish-e-Mohammad (JEM), Sajjad Afghani, and his bodyguard were killed in a gunfight along the banks of Dal Lake in Srinagar, the biggest city in Kashmir, senior police chief SM Sahai told reporters.
Afghani, who was also known among the militant ranks as "Qari Hamad", was one of the region's most wanted militants and active in north Kashmir, Sahai said, calling his killing "a major breakthrough" that had averted an attack.
"Both the militants were Pakistani nationals and were killed after a police party intercepted them while they were moving in a private car," the officer said.
It was the first major gunfight in Srinagar since the shooting of three young men in November who police said were JEM militants. Human rights groups questioned the police claims, saying they were students.
The assault on the state assembly in 2001, claimed by JEM, left about 40 people dead.
The violence has claimed at least 47,000 lives, according to the official count.
In a separate incident on Thursday, a police spokesman said the body of a 35-year-old man with his throat slit was recovered in a forest 45 kilometres north-east of Srinagar.
Three members of the same family were also critically injured on Thursday in a grenade explosion in Kupwara district 100 kilometres north of Srinagar.
"Two boys and their sister were injured when they fiddled with a live grenade which they have found near their residence," the police spokesman said.
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