Both countries have ordered airstrikes over the last two days, the first time in history that two nuclear armed powers have done so, while ground forces have exchanged fire in more than a dozen locations.
Tensions have been elevated since a suicide car bombing by Pakistan-based militants in Indian-controlled Kashmir killed at least 40 Indian paramilitary police on Feb. 14, but the risk of conflict rose dramatically on Tuesday when India launched an air strike on what it said was a militant training base.
The attack targeted the Jaish-e-Mohammed (JeM), the group that claimed credit for the suicide attack. India said a large number of JeM fighters had been killed, but Pakistani officials said the strike was a failure and inflicted no casualties.
Meanwhile, Indian defense sources reportedly told the local media that Israeli-made smart bombs were used in the airstrikes on the militant camp inside Pakistan.
According to the reports, the Indian air force used SPICE 2000 precision-guided bombs, made by Rafael Advanced Defense Systems Ltd, an Israeli munitions company formerly part of the country's Defense Ministry.
Indian air force planes strayed into Pakistani airspace on Wednesday after Pakistan carried out airstrikes in Indian-occupied Kashmir, said Major General Asif Ghafoor, a spokesman for the Pakistan armed forces.
"PAF shot down two Indian aircrafts inside Pakistani airspace," he said in a tweet.
One of the aircraft fell on India's side of Kashmir, while the second came down in Pakistani-held territory and its pilot was captured, he added.
In a statement, Pakistan's foreign ministry said it had hit a "non-military" target inside Indian-controlled Kashmir, but that it had avoided human loss and collateral damage.
"If India is striking at so called terrorist backers without a shred of evidence, we also retain reciprocal rights to retaliate against elements that enjoy Indian patronage while carrying out acts of terror in Pakistan," the statement said.
A spokesman for India's defence ministry was not immediately available for comment.
Police officials in Indian-occupied Kashmir said that two Indian pilots and a civilian had died after an Indian air force plane crashed in Kashmir, but did not confirm if the plane had been shot down by Pakistani forces.
Indian officials said three Pakistani jets had also entered Indian airspace, before being intercepted and forced turned back.
The Indian air force has ordered Kashmir's main airport in Srinagar along with at least three others in neighboring states to close because of the two incidents, an official said.
The latest exchanges hit stock markets in both countries.
Pakistani stocks fell sharply during morning trade with the benchmark KSE 100 Index down 3.34 percent and the narrower KMI 30 index down 3.6 percent in Karachi. The Indian stock market was down around 0.5 percent.
On Tuesday evening, Pakistan began shelling using heavy caliber weapons in 12 to 15 places along the de facto border in Kashmir, known as the Line of Control (LoC), a spokesman for the Indian defense forces said.
"The Indian Army retaliated for effect and our focused fire resulted in severe destruction to five posts and number of casualties," the spokesman said.
Five Indian soldiers suffered minor wounds in the shelling that ended on Wednesday morning, he added.
"So far there are no (civilian) casualties but there is panic among people," said Rahul Yadav, the deputy commissioner of the Poonch district where some of the shelling took place.
"We have an evacuation plan in place and if need arises we will evacuate people to safer areas, he said.
Officials on the Pakistani side said at least four people had been killed and seven wounded, though it was unclear if the casualties were civilian or military.
India has also continued its crackdown on suspected militants operating in Kashmir, a mountainous region that both countries claim in full but rule in part.
On Wednesday, security forces killed two Jaish militants in a gun battle, Indian police said.
Pakistan and India have fought three wars since independence from British colonial rule in 1947 and went to the brink a fourth in 2002 after a Pakistani militant attack on India's parliament.
In Mumbai, India's financial capital, there was a visible increase in security levels for a city that has suffered numerous militant attacks in the past.
US Secretary of State Mike Pompeo spoke separately with the foreign ministers of India and Pakistan and urged them to avoid "further military activity" following Tuesday's airstrike.
"I expressed to both ministers that we encourage India and Pakistan to exercise restraint, and avoid escalation at any cost," Pompeo said in a statement on Wednesday.
"I also encouraged both ministers to prioritize direct communication and avoid further military activity," he said.
Both China and the European Union have also called for restraint. On Wednesday New Zealand Foreign Minister Winston Peters also voiced concern over the escalation in tension.
In Afghanistan, the Taliban urged both sides to mediate via talks, and that further escalation could impact the Afghan peace process.
"India should not carry any further violence in Pakistan because its continuation will affect regional security also the continuation of such conflict will cost a lot for India," Taliban spokesman Zabiullah Mujahid said in a statement.