Sabah Police Chief Hamza Taib said two police officers and 12 Filipino rebels had been killed at Lahad Datu.

Lahad Datu was occupied in early February by members of a Muslim royal clan from the Philippines calling itself the Royal Army of Sulu.

They are demanding recognition as the rightful owners of Sabah province.

The group - some of them armed - had been urged to end their siege by both the Malaysian and Philippine governments.

Hamza Taib said the killings happened during a 30-minute shoot-out on Friday morning, when members of the clan opened fire as the security forces were tightening a security cordon around the village.

He told the Associated Press that the stand-off was continuing. "We don't want to engage them but they fired at us. We have no option but to return fire," he said.

But confusion remains over what exactly has happened in the remote part of Sabah.

The leader of the gang, Agbimuddin Kiram, told a Philippines radio station that police had surrounded them and opened fire.

"They are here, they entered our area so we have to defend ourselves. There's shooting already," he told Manila-based DZBB radio.

"We're surrounded. We will defend ourselves," he said. The group has put its death toll at 10.

Malaysian Prime Minister Najib Razak confirmed that two police officers had died and three were wounded, and said between 10 and 12 clan members had been killed.

He said he had given the security forces "full power" to do what was necessary to "defeat" the group, according to Malaysia state news agency Bernama.

"I am very sad over the incident because what we had wanted to prevent, which is bloodshed, had actually happened," the prime minister said.

Mr Kiram, the younger brother of the self-proclaimed Sultan of Sulu Jamalul Kiram III, led the gang of at least 100 from their home on the Philippine islands of Sulu in early February to the shores of Sabah.

The Sulu Sultanate once spread over several southern Philippine islands as well as parts of Borneo, and claimed Sabah as its own before it was designated a British protectorate in the 1800s.

Sabah became part of Malaysia in 1963, and the country still pays a token rent to the Sulu Sultanate each year.

The Royal Army of Sulu wants Malaysia to recognise it as the rightful owner of Sabah, and to renegotiate the terms of the old lease - something Malaysia has made clear it has no intention of doing.