Thousands of villagers poured onto the streets for the funeral, chanting slogans against Indian rule and pelting stones at soldiers who responded with bullets and pellet fire, a police officer said.
S P Vaid, director general of police for the territory, confirmed a protester was killed in the exchange.
Another police officer, speaking on condition of anonymity, said at least a dozen others were injured by pellets fired by government forces to disperse the angry crowd.
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On Wednesday night soldiers and counter-insurgency police surrounded a residential area where they suspected armed militants were hiding out, triggering a fierce exchange of fire.
Scores of residents then emerged from their homes to pelt stones at the soldiers in a bid to help the militants escape, a police officer said.
"Three terrorists were killed and three weapons recovered from the site," army spokesman Colonel Rajesh Kalia said earlier Thursday.
Witnesses said the army blew up the house where the 'militants' were hiding in Kakapora, 30kms south of Srinagar.
One soldier was also injured in the gun battle, police said.
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