India's foreign ministry ordered Pakistan's Acting High Commissioner, Jalil Abbas Jilani, and four other embassy staff to leave the country within 48 hours.
Pakistan quickly retaliated, ordering five of India's diplomats out, including Acting High Commissioner Sudhir Vyas.
Indian Foreign Ministry spokesman Navtej Sarna says the Pakistanis were expelled because they were "indulging in activities incompatible with their official status."
New Delhi's expulsion order came a day after Indian police alleged that Mr. Jilani had given more than $6,000 to a Kashmiri woman to pass onto Muslim separatists in Indian Kashmir. Mr. Jilani has strongly denied the allegations, saying it was an attempt to harass Pakistani diplomats.
India accuses Pakistan of arming, training and financing Muslim separatist groups fighting Indian rule in Kashmir, charges that Islamabad rejects.
Indian Prime Minister Atal Behari Vajpayee has accused Pakistan of doing nothing to end "terrorism" against India. He told a security conference in New Delhi Saturday that Islamabad has not dismantled militant training camps in its own territory, and had also begun infiltrating militants into India across India's borders with Nepal and Bangladesh.
The two nuclear-armed countries came close to war last year, after India blamed Pakistani-based militants for an attack on the Indian parliament building. Although the military standoff has eased, relations continue to be strained. New Delhi has refused to enter into talks with Islamabad despite intense international pressure.
Kanti Bajpai is a foreign affairs expert at New Delhi's Jawaharlal Nehru University. He said the latest diplomatic expulsions rule out any prospect of an improvement in relations. "It's just going to be fairly grim days ahead, without any talks. There will be a spate of eruptions verbally," he said. "I don't think it will get militarized, because there are too many things brewing, and both sides realize that's a no-win situation all round."
Pakistan's Information Minister, Sheikh Rashid Ahmed, called the Indian move "diplomatic terrorism", and said it was an attempt to derail prospects of improved ties between the two countries.