Houses on the island are said to be on fire after the artillery exchange North Korea has fired artillery shells across its western maritime border, prompting return fire from South Korea, officials say.
Dozens of the shells landed on a South Korean island, from which plumes of smoke are rising. At least four soldiers are said to have been hurt.
South Korea has issued its highest non-wartime alert in response.
A BBC correspondent says this is one of the most serious incidents between the two Koreas since the end of the war.
Top leaders are meeting in an underground bunker in Seoul over the incident, Reuters news agency reported.
The incident comes days after North Korea revealed it had a modern uranium enrichment plant – potentially giving it a second route to a nuclear weapon.
Earlier, the US ruled out more denuclearisation talks while Pyongyang continued to work on the facility.
South Korean officials said artillery rounds landed on Yeonpyeong island, near the disputed inter-Korean maritime border to the west of the Korean Peninsula.
“A North Korean artillery unit staged an illegal firing provocation at 1434 PM (0534 GMT) and South Korean troops fired back immediately in self-defence,” a defence ministry spokesman told AFP.
A resident on the island told the agency that dozens of houses were damaged, while television pictures reportedly showed plumes of smoke rising above the island.
“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 station.
“People are frightened to death and shelling continues as we speak,” the witness said.
South Korea had deployed fighter jets to the island, Yonhap news agency said.
This western maritime border has been the scene of numerous clashes between the two Koreas in the past.
In March, a South Korean warship went down near the border with the loss of 46 lives.
International investigators say a North Korean torpedo sank the ship, although Pyongyang denies any role in the incident.
Since then relations between the two neighbours – who have not signed a peace treaty since the 1950-53 Korean War – have been very tense.
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