By Asif Shahzad, Ariba Shahid and Fayaz Bukhari

ISLAMABAD/SRINAGAR, India (Reuters) - In a significant escalation of tensions between two of South Asia's nuclear-armed neighbors, Pakistan announced the closure of its airspace to Indian airlines and officially rejected India's recent suspension of a vital water-sharing treaty. This retaliatory move comes in response to Indias reaction to a tragic Islamist militant attack that claimed the lives of 26 tourists in Indian-administered Kashmir.

The situation marks the lowest point in relations between India and Pakistan in years, with both countries having a fraught history characterized by three wars and numerous skirmishes. The latest diplomatic crisis erupted following a brutal attack on Tuesday, which is considered the deadliest assault on civilians in India since the 2008 Mumbai terror attacks.

Indian authorities reported that the attack had cross-border elements, leading them to downgrade diplomatic ties with Pakistan. On Wednesday, India announced the suspension of the 1960 Indus Waters Treaty, which had been intended to regulate the sharing of water resources from the Indus River and its tributaries. Additionally, India closed its sole land border crossing with Pakistan.

In a notable development, Indian police released notices identifying three suspects related to the attack, alleging that two of them are Pakistani nationals. However, the Indian government has so far failed to provide any concrete evidence to substantiate these claims or to offer further information about the suspects.

On Thursday, Pakistan responded firmly by closing its airspace to all Indian-owned or operated flights, as well as halting trade activities, even those via third countries. Special South Asian visas issued to Indian citizens will also be suspended. The Prime Minister's office in Islamabad indicated that Pakistan would be putting all bilateral agreements with India on hold, including the pivotal 1972 Simla Agreement, until India ceases what Pakistan describes as fomenting terrorism on its soil.

The Simla Agreement, forged in the aftermath of the third Indo-Pakistani war, was designed to create a framework for peaceful relations between the two countries and emphasized respect for the ceasefire line in Kashmir. However, under the current circumstances, there has been no immediate response from Indian authorities regarding Pakistan's latest actions.

Amidst rising tensions, Pakistan's government bonds, which are denominated in US dollars, saw a sharp decline of more than 4 cents on Thursday as investor confidence wavered.

The Kashmir region, which has a majority Muslim population, has long been a focal point of hostility between India and Pakistan. Both countries claim the territory in full but administer only parts of it, leading to a conflict that has resulted in two of the three wars fought between them. The region has also been the epicenter of a violent insurgency against Indian governance.

Moreover, Islamabad expressed its strong opposition to India's suspension of the Indus Waters Treaty, stating that any move to obstruct or redirect water allocated to Pakistan would be regarded as an act of war and would provoke a substantial response utilizing the full range of Pakistan's national power.

The Indus Waters Treaty, brokered by the World Bank, has historically managed to withstand periods of extreme hostility between the two nations. It delineates the rights to the Indus River and its tributaries, and Pakistan heavily relies on the waters flowing from this system for its agriculture and energy needs. A suspension of this treaty would enable India to restrict Pakistan's water supply, potentially leading to dire consequences.

This diplomatic standoff intensified rapidly after Indian Prime Minister Narendra Modi publicly vowed to hunt down and punish the militants responsible for the attack on tourists in Kashmir's Pahalgam area. The Indian government also announced the cessation of all visa services for Pakistani nationals and the revocation of previously issued visas.

In a solemn public address ahead of an event in Bihar, Modi urged the audience to join him in paying respects to the victims, stating, We will pursue them to the ends of the earth. He refrained from specifically naming Pakistan or the attackers but emphasized that those responsible for the assault would face severe repercussions.

Later in the day, Modi convened an all-party meeting with opposition leaders to discuss the government's strategy in response to the attack.

In New Delhi, protests erupted outside the Pakistani embassy, with demonstrators chanting slogans and confronting police barricades in a show of national solidarity against terrorism.

In a reflection of the deteriorating cultural ties between the two nations, a film featuring Pakistani actor Fawad Khan opposite Bollywood star Vaani Kapoor has reportedly been pulled from release in India, according to sources in the federal information ministry.

Prior to these latest developments, diplomatic relations had already been strained; Pakistan expelled India's envoy and did not appoint a new ambassador in New Delhi following India's revocation of the semi-autonomous status of Kashmir in 2019. The recent attack is seen as a significant setback to the Indian government's narrative that it has brought stability and growth to the troubled region of Jammu and Kashmir, which has been marked by conflict and unrest for decades. While India has consistently accused Pakistan of supporting insurgency in Kashmir, Pakistan maintains that it only extends diplomatic and moral backing for the Kashmiri people's right to self-determination.

Since the onset of the insurgency in Kashmir in 1989, tens of thousands have lost their lives, but incidents of violence have decreased in recent years, leading to a resurgence in tourism within the region.

(Reporting by Asif Shahzad and Ariba Shahid in Islamabad; Fayaz Bukhari and Shivam Patel in Srinagar; Writing by Shilpa Jamkhandikar and YP Rajesh; Editing by Kevin Liffey and Sharon Singleton)