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Pakistan halted cross-border trade and bus travel across the Himalayan region after the seizure last week, and on Tuesday New Delhi summoned Pakistan's acting envoy in protest.
The two nuclear-armed countries have fought two wars over Kashmir but had sought to ease access and commerce in a region at the heart of more than 60 years of hostility.
The spat, which comes after the two sides agreed on Saturday to allow round-the-clock movement of trucks and containers through their main border crossing further south in Punjab, underlines the fragility of the peace process.
"It is indeed surprising that Pakistan chose to hold hostage trans-LoC trade and travel bringing immense humanitarian benefits to the people of Jammu and Kashmir, for the sake of persons indulging in drug trafficking," Foreign Ministry spokesman Syed Akbaruddin said, referring to the Line of Control dividing Kashmir.
Both Prime Minister Manmohan Singh and Pakistan counterpart Nawaz Sharif, who took power last year, are keen to rebuild ties and diplomats say closer integration of Pakistan with India's giant economy could lay the ground for improving political relations.
The latest row erupted on Friday when police impounded a truck coming from Chakoti on the Pakistan side of Kashmir and arrested its driver saying they had found 114 packets of heroin concealed in a cargo of almonds.
Deputy Police Inspector General J P Singh said the seizure was the largest contraband haul since cross-border trade began across the heavily militarised Line of Control in 2008, and estimated that it could be worth Rs 100 crore on the international market.
He said the almonds were meant for a businessman in Bandipora on the Indian side of Kashmir and that police were carrying out raids to hunt drug smugglers.
"We have followed the procedures. We have seized contraband, we have registered a case and when you register a case you have to arrest the driver who was carrying it, according to our laws," Singh said, adding it was wrong for Pakistan to stop all movement across Kashmir.
But Pakistan said India often caused problems on the Kashmir border with unsubstantiated allegations.
"It's not for the first time they have resorted to such a practice. Previously on at least five occasions, they levelled baseless allegations, from recovery of weapons to cocaine to counterfeit currency from our trucks," said retired brigadier Muhammad Ismail, the head of Azad Kashmir Travel and Trade Authority.
He said no evidence had ever been presented.
A group of 26 people, most of them from the Pakistani side of Kashmir, are now stranded because their bus was turned back at the crossing. Trucks that carry goods across the two parts of Kashmir are also stuck.
