South Korean President Lee Myung-bak, who has pursued a hard line with the reclusive North since taking office nearly three years ago, said a response had to be firm following the attack on Yeonpyeong island, just 120 km (75 miles) west of the capital Seoul.
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.
"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.
"People are frightened to death and shelling continues as we speak."
YTN said at least 200 North Korean shells hit Yeonpyeong, which lies off the west coast of the divided peninsula near a disputed maritime border. Most of the shells landed on a South Korean military base there.
South Korea's military said one soldier was killed and three seriously injured in the attack. South Korean military returned the fire and sent a jet fighter to the area.
YTN showed pictures of plumes of smoke pouring from the island and quoted a witness as saying fires were burning out of control.
It said many of the shells had landed on a military base on the island, about 3 km (1.8 miles) south of the disputed sea border.
A witness said residents had been evacuated during the shelling which lasted for about an hour and then stopped abruptly.
News of the exchange of fire sent the won tumbling in offshore markets with the 1-month won down about four percent in NDF trading. U.S. 10-year Treasury futures rose and the Japanese yen fell.
It also rattled already global markets, already unsettled by Ireland's debt problems and worries about riskier markets.
The South Korean central bank said it would hold an emergency meeting to assess the possible market impact of the shelling.
The attack comes just as a U.S. envoy is travelling to the
region after revelations that the North is moving ahead with uranium enrichment, a possible second path to manufacture material for atomic weapons.
North Korea has said it wants to restart six-party nuclear disarmament talks it abandoned two years ago. But Seoul and Washington have said the North must move forward with previous pledges to curtail its nuclear programme.
"It's unbelievable," said Zhu Feng, professor of international relations at Peking University. "Today's news proves that North Korea, under unprovoked conditions, shot these South Korean islands. It's reckless provocation. They want to make a big bang and force the negotiations back into their favour. It's the oldest trick."
There was no immediate comment from the White House and State Department. China, the closest the isolated state of North Korea has to an ally, expressed concern about the incident.
The impoverished North depends heavily on China for economic and diplomatic support and its leader, Kim Jong-il, has visited China twice this year, in part to gain backing for the anointment of his son to eventually take over the family dynasty.
Those ties have become a sore-point with Washington after reports that North Korea appears to have made big steps towards enriching uranium, possibly using technology that passed through or even originated in China.
A U.S. academic, Siegfried Hecker, who recently visited North Korea, said at the weekend that he had seen more than a thousand centrifuges for enriching uranium during a tour of the North's Yongbyon nuclear complex.
Sung Kim, a U.S. official dealing with North Korean issues, said in Washington D.C. on Monday that China's ties its chairing of stalled talks aimed at ending Pyongyang's nuclear weapons capability mean "they do have a special responsibility to deal with the challenges posed by North Korea."
China has urged returning to the nuclear disarmament negotiations but has also fended off calls from the U.S. and its regional allies to use its vital food and energy aid to North Korea as a lever.