(Adds report of machinegun fire)
By Satarupa Bhattacharjya
NEW DELHI, Jan 15 (Reuters) - Indian Prime Minister Manmohan Singh said on Tuesday there could be no "business as usual" with Pakistan after a clash last week along the line dividing the arch-rivals in Kashmir in which two Indian soldiers were killed and their bodies mutilated.
Speaking to reporters at a ceremony to mark India's Army Day, Singh said that the killings on Jan. 8 on the Line of Control, in which one of the soldiers was beheaded, were a "barbaric act".
His remarks came after Indian army chief General Bikram Singh said his country reserved the right to retaliate and he had instructed his ground commanders to respond to any provocation aggressively.
Adding to the tensions, troops from both sides exchanged machinegun fire across the line for more than two hours on Tuesday night, Indian army intelligence officials told Reuters.
No one was injured and no property was damaged during the latest shooting in Poonch district, they added.
Despite each side blaming the other for the worst outbreak of violence in the area since a ceasefire was agreed nine years ago, analysts said a breakdown in ties between the nuclear-armed neighbours was highly unlikely.
Singh has been pushing for a rapprochement with Pakistan, despite opposition not only from the main rival political party but also from within his ruling coalition.
Yet Indian Foreign Minister Salman Khurshid said ties could not remain unaffected by the flare-up on the border.
"Such actions by the Pakistan army which are in contravention of all norms of international conduct not only constitute a grave provocation but lead us to draw appropriate conclusions about Pakistan's seriousness in pursuing normalisation of relations with India," he added.
Each army has lost two soldiers in fighting along parts of the 740-km (460-mile) de facto border this month.
The decapitation of one of the Indian soldiers provoked outrage in the country and demands of retribution including from his family which wanted the severed head of the soldier back.
Pakistan has dismissed the Indian allegations as propaganda and instead accused India of violating the ceasefire in Kashmir, which has been the cause of two of three wars between the two neighbours.
But Khurshid said New Delhi had asked Pakistan's government to conduct an investigation into the attack and ensure that the grave act by its army was not repeated.
"It should not be felt that the brazen denial and a lack of proper response from the government of Pakistan to our repeated demarches (official statements) on this incident will be ignored and that bilateral relations could be unaffected or that there will be 'business as usual'," he said in a statement.
The two countries have been trying to revive a peace process that went into deep freeze after the Mumbai attacks in November 2008 by a Pakistan-based militant group.
Pakistan remained committed to the peace process, a foreign ministry spokesman said in a statement on Tuesday.
"Pakistan attaches great importance to the ongoing peace process with India, and is committed to resolve the issue of LOC violations under the agreed mechanism," the spokesman said.
He added that Pakistan's offer to hold an investigation by the United Nations Military Observer's Group for India and Pakistan remained on the table.
India rejects any involvement of the U.N. group, considering the whole of Kashmir as an integral part of the country.
(Additional reporting by Annie Banerji; Katharine Houreld in Islamabad; Writing by Sanjeev Miglani; Editing by Jason Neely)