India halted peace talks with Pakistan after the November 2008 Mumbai attacks in which 166 people were killed and which India has blamed on Pakistan-based groups.

A meeting between the leaders is seen as crucial because it could help keep alive engagement between two countries whose battle for influence in Afghanistan has a direct bearing on Western efforts to stabilize a region with 1.8 billion people.

"It has been agreed through diplomatic channels that prime ministers of India and Pakistan will hold a bilateral meeting at Thimphu on Thursday," the Indian Foreign Ministry said in a statement.

The Pakistani ministry issued the same statement. Neither gave any information about what the two leaders might discuss.

Pakistani Prime Minister Yousaf Raza Gilani and his Indian counterpart, Manmohan Singh, are in Bhutan for a summit of South Asian leaders.

The two South Asian rivals, who have fought three wars since their independence from Britain in 1947, have been tentative about engaging since their top diplomats met in New Delhi in February but failed to achieve a breakthrough.

That meeting, nonetheless, was seen as a small step toward repairing ties.

The United States has been urging the two sides to reduce tension so that Pakistan can focus better on fighting the Taleban on its western border with Afghanistan.

The announcement came a day after New Delhi said a woman diplomat working at the Indian Embassy in Islamabad was arrested on suspicion of passing secrets to Pakistani intelligence.

Speaking to reporters in Thimphu on Tuesday, Pakistani Foreign Minister Shah Mahmood Qureshi said any meeting should address the need to resume a full-fledged peace dialogue.

"It's time for India to make up its mind whether it wants to engage or not... Engagement is the only way forward," he said.

"We need to go beyond a handshake," Qureshi said, referring to Singh and Gilani's cursory exchange of pleasantries at a summit on nuclear security in Washington earlier this month.

The two prime ministers were in the Bhutanese capital to attend the 16th summit of the eight-nation South Asian Association for Regional Cooperation (SAARC), which groups Afghanistan, Bangladesh, Bhutan, India, the Maldives, Nepal, Pakistan and Sri Lanka.

Qureshi said it was time for India to move forward and stop demonizing Pakistan.

"We have to accept terrorism is a common challenge. It's not us and you, it's a collective effort," he said.

Qureshi attended a meeting of SAARC foreign ministers Tuesday along with his Indian counterpart S.M. Krishna, who urged member states to "rally against the forces of terrorism".

"The South Asian region is particularly afflicted by this menace," Krishna said.

India and Pakistan are locked in a struggle for influence in Afghanistan, which joined SAARC in 2007.

The spying scandal that erupted Tuesday involves a 53-year-old junior diplomat working in the information service of the Indian Embassy in Islamabad.

The woman, Madhuri Gupta, a second secretary in the embassy, was arrested for breaching the official secrets act, which carries a minimum 10-year jail term. The source said she had been under surveillance for six months.

The Press Trust of India said she had worked in the mission for nearly three years and is alleged to have passed on information from the Islamabad head of India's external intelligence service.