* India summons Pakistan's envoy to lodge "strong protest"
* Most serious incursion along de facto border since 2003 ceasefire
* Indian foreign minister says escalation must be avoided
* Pakistan dismisses Indian allegations as "baseless and unfounded" (Updates throughout)
By Ashok Pahalwan
JAMMU, India, Jan 9 (Reuters) - India denounced Pakistan on Wednesday over a firefight in the disputed territory of Kashmir in which two Indian soldiers were killed, but the nuclear-armed rivals both appeared determined to prevent the clash escalating into a full diplomatic crisis.
India summoned Pakistan's envoy in New Delhi to lodge a "strong protest", accusing a group of Pakistani soldiers it said had crossed the heavily militarised Line of Control (LoC) in Kashmir of "barbaric and inhuman" behaviour.
The body of one of the soldiers was found mutilated in a forested area on the side controlled by India, Rajesh K. Kalia, spokesman for the Indian army's Northern Command, said. However, he denied Indian media reports that one body had been decapitated and another had its throat slit.
"Regular Pakistan troops crossed the Line of Control ... and engaged the Indian troops who were patrolling the sector," India's Ministry of External Affairs said in a statement after Pakistan's high commissioner to India had been called in.
"Two Indian soldiers were killed in the attack and their bodies subjected to barbaric and inhuman mutilation."
India's foreign minister sought to cool tensions, however, saying that exhaustive efforts to improve relations could be squandered if the situation was not contained.
"I think it is important in the long term that what has happened should not be escalated," Salman Khurshid told a news conference. "We cannot and must not allow the escalation of any unwholesome event like this."
"We have to be careful that forces ... attempting to derail all the good work that's been done towards normalisation (of relations) should not be successful," he added, without elaborating on who such forces might be.
MOST SERIOUS INCIDENT IN 10 YEARS
India and Pakistan have fought three wars since their independence in 1947, two of them over the Himalayan region of Kashmir, and both are now nuclear-armed powers.
Away from the border, ties had appeared to be improving of late. Pakistan's cricket team completed a two-week tour of India on Sunday, its first visit in five years.
Firing and small skirmishes are common along the 740-km (460-mile) LoC despite a ceasefire that was agreed in 2003.
However, incursions by troops from either side are rare. Retired Indian army Brigadier Gurmeet Kanwal, who previously commanded a brigade on the LoC, said Tuesday's incident - about 600 metres from the de facto border - marked the most serious infiltration since the ceasefire was put in place.
Indian army officials said cross-border firing broke out hours after the clash but, on Wednesday, the LoC was quiet.
Naveed Chand, a shopkeeper in Chatar village just 2 km from the LoC on the Pakistani side told Reuters by telephone that there had been a pick-up in cross-border firing recently, unusual movements of army trucks and reinforcement of bunkers.
"We think something is up. People in the area are very alarmed," he said.
It was not possible to independently verify events in the remote area, which is closed to journalists on both sides.
Pakistan's foreign ministry denied India's allegations of an incursion as "baseless and unfounded" and said in a statement that it was prepared for an investigation by a U.N. military observer group into recent ceasefire violations.
Like New Delhi, it stressed the need to pursue better relations, adding: "Pakistan is committed to a constructive, sustained and result-oriented process of engagement with India."
Nevertheless, a Pakistani army spokesman described India's charges as "propaganda" aimed at diverting attention away from an Indian incursion two days earlier in which one Pakistani soldier was killed. India denies that its troops crossed over the line during last weekend's incident.
Mushahid Hussain, a Pakistani senator and member of the Parliamentary Committee on National Security, said the Indian government - dogged by corruption scandals and facing a tough election as early as this year - was returning to "the war-like language of the past" for domestic political reasons.
"Pakistan has its hands full with a full-blown insurgency inside its borders. It doesn't suit Pakistani interests at all to raise the temperature along the LoC," Hussain said.
There was little coverage of the skirmish in Pakistani media, but a succession of commentators voiced fury on Indian news channels and the main opposition party urged the government to expose Pakistan's actions to the international community.
"Pakistan can be named and shamed for this brutal attack," Bharatiya Janata Party leader Arun Jaitley told reporters.
India considers the entire Kashmir region of snow-capped mountains and fertile valleys an integral part of its territory. Muslim Pakistan contests that and demands implementation of a 1948 U.N. Security Council resolution for a plebiscite to determine the wishes of the mostly Muslim people of Kashmir.
Some commentators drew parallels between Tuesday's clash and a conflict in 1999 when Pakistan-backed Islamist infiltrators occupied the heights in Kargil, in the north of Indian Kashmir. India lost hundreds of troops before re-occupying the mountains after fighting that almost triggered a fourth war.
"India's response will be measured but, as a former soldier, I do not rule out a measured military response to teach them a lesson," said retired Brigadier Kanwal. "You cannot tinker with bodies." (Additional reporting by Mehreen Zahra-Malik and Katharine Houreld in ISLAMABAD and by Sanjeev Miglani, Arup Roychoudhury and Satarupa Bhattacharjya in NEW DELHI; Writing by John Chalmers; Editing by Robert Birsel)