NEW DELHI - Indian and Pakistani troops traded small-arms fire on Tuesday along their tense frontier in Kashmir as Indian Prime Minister Atal Behari Vajpayee raised hopes of avoiding an all-out war.

An Indian defence official said both armies -- involved in a powerful build-up along their border -- exchanged machine gun fire in several Kashmir frontier areas overnight and into Tuesday.

At least seven Pakistani civilians, three of them children, were killed on Monday in cross-border firing.

The two nations have mobilised about a million troops along their border from Kashmir in the Himalayas to the Arabian Sea after a bloody December attack on India's parliament which New Delhi blamed on Pakistan-based Muslim militants fighting its rule in Kashmir.

India says it will not scale down its deployment until Pakistan ends support for the militants. Pakistan denies sponsoring the groups and has banned several.

In Srinagar, summer capital of disputed Kashmir, Indian forces were locked in a fierce gunbattle with rebels.

At least one border guard was killed in the firefight, which continued into the afternoon despite the house the three rebels are holed up in catching fire, police said.

Police said the clash in a residential suburb began late on Monday night. In October, 38 people died in a suicide bomb attack on the state assembly in the city.

Indian Prime Minister Atal Behari Vajpayee said late on Monday he did not expect the tensions with Pakistan to boil over into war, adding diplomatic efforts were making some progress.

INDIA REJECTS TALKS

But at the same time, he rejected Pakistan's latest offer of discussions and urged Islamabad to return the roughly one third of Kashmir it controls before any talks.

"If Kashmir is the central issue, then one third of Kashmir is occupied by Pakistan illegally," the Press Trust of India quoted Vajpayee saying. "Therefore, they should return that to India and then start talks."

Pakistan's top military spokesman, Major-General Rashid Qureshi, told Reuters Islamabad was "evaluating" Vajpayee's latest comments.

With a harsher than normal winter hitting the Himalayas and large-scale military action unlikely before spring anyway, analysts saw no significant change in Vajpayee's position.

"The position has remained the same. It is a strategy of using coercive diplomacy and force to ensure that Pakistan is under pressure to end cross-border terrorism," C. Raja Mohan, The Hindu newspaper's strategic affairs editor, told Reuters.

India would wait for Islamabad to hand over men on a list of 20 alleged terrorists and criminals it says are sheltering in Pakistan and for evidence militants had stopped slipping into Indian Kashmir, he said.

"Once that happens, there will be diplomatic de-escalation and then negotiations," Mohan said.

Indian Home (Interior) Minister Lal Krishna Advani said last week it would take at least another two months, until after the winter peak, to be able to determine if the number of infiltrations was falling or had stopped. Nampa-Reuters