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.
Pyongyang accused the South of firing first. The Southern military said it had conducted exercises but shelling was directed away from the North.
This is one of the worst clashes since the Korean War ended, analysts say.
There have been occasional cross-border incidents since the conflict ended without a peace treaty in 1953, but the latest 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, it emerged that North Korea had also shown off what it claimed was a new uranium enrichment facility to an American scientist.
The move prompted the US to rule out the resumption of six-party talks on nuclear disarmament that Pyongyang abandoned two years ago.
White House press secretary Robert Gibbs called on North Korea to "halt its belligerent action", adding that the US was "firmly committed" to South Korea's defence.
An emergency session of the United Nations Security Council could be held on Tuesday or Wednesday, a French diplomatic source said.
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 of them hitting a South Korean military base there. Sixteen South Korean marines and three civilians were injured.
A resident on the island told the AFP news agency that dozens of houses had been damaged by the barrage. Television pictures showed plumes of smoke rising above the island.
"Houses and mountains are on fire and people are evacuating," 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.
"All of the island's 1,600-odd residents were evacuated to shelters," he said.
The South's military fired back some 80 shells. Casualties on the northern side are unknown.
South Korean fighter jets were also deployed to Yeonpyeong, which lies about 3km (1.8 miles) south of the disputed inter-Korean maritime border.
President Lee Myung-bak ordered the military to retaliate against North Korean targets in case of "additional provocations", his spokesman said.
Earlier, the president's office said: "North Korea's shelling of Yeonpyeong island constitutes a clear armed provocation."
But North Korea's supreme military command blamed South Korea for the incident.
"The South Korean enemy, despite our repeated warnings, committed reckless military provocations of firing artillery shells into our maritime territory near Yeonpyeong island beginning 1300 (0400 GMT)," the state-run KCNA news agency quoted it as saying.
The North would "continue to make merciless military attacks with no hesitation if the South Korean enemy dares to invade our sea territory by 0.001mm", it warned.
"It is our military's traditional response to quell provocative actions with a merciless thunderbolt."
South Korean military officials later said that it had been conducting regular military drills in the sea off Yeonpyeong before the incident, but that no fire was aimed towards North Korea.
There was more condemnation of North Korea from Russia, EU and the UK, although China - the North's main ally - refused to apportion blame.
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.
Russia's foreign minister warned of a "colossal danger", and said those behind the attack carried a huge responsibility.
The BBC's John Sudworth in Seoul says news of the incident has caused concern on international financial markets, with both the Korean won and Japanese yen falling, but there is no sign of panic in the South Korean capital.
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.
Since then relations between the two neighbours have remained tense.