South Korea warned North Korea on Tuesday of "enormous retaliation" if it took more aggressive steps after Pyongyang fired scores of artillery shells at a South Korean island in one of the heaviest attacks on its neighbor since the Korean War ended in 1953.
The South fired back after Tuesday's attack and sent fighter jets to the area, close to a disputed maritime border on the west of the divided Korean peninsula and the scene of deadly clashes between the two rivals in the past.
South Korea was conducting military drills in the area at the time but said it had not been firing at the North. Pyongyang blamed Seoul for starting the fight, which killed two South Korean soldiers and wounded 17 others along with three civilians and razed scores of houses.
Calling the incident "an invasion of South Korean territory", South Korean President Lee Myung-bak warned that future provocations could be met with a strong response, although there was no indication of immediate retaliation.
"I think enormous retaliation is going to be necessary to make North Korea incapable of provoking us again," Lee, who has taken a tough line on North Korea, told reporters during a visit to military headquarters in Seoul.
The United States, which has 28,000 troops in South Korea, condemned the attack, but said it was too soon to discuss ways the U.S. military might deter the reclusive communist state from another strike.
U.N. Secretary General Ban Ki-moon also condemned the attack, which he called "one of the gravest incidents since the Korean War," but urged restraint and said the two sides should resolve differences through dialogue.
ADDING TO TENSION
The incident followed revelations over the weekend that Pyongyang is fast developing another source of material to make atomic bombs, and analysts said the North may again be pursuing a strategy of calculated provocations to wrest diplomatic and economic concessions from the international community.
It also follows moves by leader Kim Jong-il to make his youngest, but unproven, son his heir apparent, leading some analysts to suggest the bombardment might in part have been an attempt to burnish the ruling family's image with the military.
"Houses and mountains are on fire and people are evacuating. You can't see very well because of plumes of smoke," a witness on the island told YTN Television.
The South Korean military estimated some 100 shells landed on and near Yeonpyeong island, which lies off the west coast of the peninsula. It returned fire with 80 of its own shells.
Photographs from the island, 120 km (75 miles) west of Seoul, showed smoke rising from buildings. Two soldiers were killed and 17 wounded. Three civilians were hurt, while the rest were evacuated from the island after the attack.
The attack rattled global markets, already unsettled by Ireland's debt woes and a shift to less risky assets.
Experts say North Korea's Kim has for decades played a carefully calibrated game of provocation to squeeze concessions from the international community and impress his own military. The risk is that the leadership transition has upset this balance and that events spin out of control.
South Korea's Lee said attacking civilians was unforgivable and any further aggression by Pyongyang would be severely punished.
"Our military should show this through action rather than an administrative response" such as statements or talks, said Lee, who was due to speak to U.S. President Barack Obama by phone about the incident.
But Lee made no suggestion the South would retaliate further, suggesting Seoul was taking a measured response.
North Korea, for its part, kept up the bellicose rhetoric, warning in a military communique of "merciless counter-actions" if South Korean forces violate any of its territory.
The North has a huge array of artillery pointed at Seoul that could decimate an urban area home to around 25 million people and cause major damage to its trillion-dollar economy.
The two Koreas are still technically at war -- the Korean War ended only with a truce -- and tension rose sharply early this year after Seoul accused the North of torpedoing one of its navy vessels, killing 46 sailors.
North Korea, which has frequently protested joint U.S.-South Korean military exercises, said its wealthy neighbor was to blame.
"Despite our repeated warnings, South Korea fired dozens of shells from 1 p.m. ... and we've taken strong military action immediately," its KCNA news agency said in a brief statement.
South Korea said it had been conducting military drills in the area beforehand but had fired west, not north.
The White House said Obama was "outraged" by the incident, which looked likely to complicate Washington's campaign to persuade Pyongyang to drop its nuclear program.
"North Korea has a pattern of doing things that are provocative. This is a particularly outrageous act," said White House spokesman Bill Burton.
But while the United States reiterated its commitment to defending the South, the Pentagon said no immediate action was planned.
"I wouldn't say we're looking at anything in particular at this point," said Colonel Dave Lapan, a Pentagon spokesman.
The attack highlighted the limits of U.S. leverage with North Korea and its main ally China, with some Republican lawmakers calling for more forceful response.
"Maybe this attack will wake up American diplomats addicted to soft-line diplomacy," Republican Congressman Ed Royce said in a statement.
With about 28,000 U.S. troops in South Korea, the two nations' combined forces face an estimated 1 million North Korean soldiers in one of the world's biggest standing armies.
Stephen Bosworth, the U.S. envoy on North Korea who was in Beijing for talks, said all sides agreed restraint was needed. "We both share a view that such conflict is very undesirable, and I expressed to them the desire that restraint be exercised on all sides and I think we agree on that," he said.
China was careful to avoid taking sides, calling on both Koreas to "do more to contribute to peace."
At the United Nations, Security Council diplomats said discussions were under way over how to take up the issue, but North Korea's envoy said council had no business discussing the incident.
Russian Foreign Minister Sergei Lavrov called the escalation in tensions a "colossal danger."
News of the exchange of fire sent the won tumbling in offshore markets with the 1-month won KRW1MNDFOR= down about four percent at one stage in NDF trading. U.S. 10-year Treasury futures TYc1 rose and the Japanese yen fell.
Korean stocks traded in New York fell 4 percent, led lower by a sharp sell-off in shares of companies like Korea Electric Power and steel producer Posco.
Overall, major U.S. stock market indexes fell more than 1 percent as the rising tensions on the Korean peninsula added to worries about global economic conditions. The U.S. dollar was up 1 percent against a basket of currencies as investors sought the safety of the greenback.
The South Korean central bank, after an emergency meeting, said it planned to cooperate with the government to take measures to stabilize markets if necessary. Many traders expect South Korea's financial markets to fall further when trading opens on Wednesday.
But analysts said the attack was not likely to escalate into a more serious military confrontation and so any market losses would be temporary. Past provocations by Pyongyang have had only a fleeting negative effect on South Korean markets.
Washington has branded the North a danger to the region and expressed concern Pyongyang would sell nuclear weapons technology to other states. It has said it was ready to return to negotiations with North Korea but wants to see more commitment to denuclearization first.
The North depends heavily on China for economic and diplomatic support and Kim Jong-il has visited China twice this year, in part to gain backing for his succession plans.