The incident took place Saturday afternoon in Bishnupura village of Rupandhei district, 20 km south from Lumbini, the birthplace of Lord Buddha.
Rajendra Dhakal, superintendent of police in Rupandhei district, said an Indian national, Surf Raj, 30, was killed by the police while he was trying to flee from the police patrol.
Nepal Police have beefed up security for the upcoming visits of Indian Prime Minister Narendra Modi to Lumbini Nov 28 and President Mahinda Rajapaksa of Sri Lanka Nov 25, a day ahead of the Saarc summit.
The police recovered two pistols and two motorcycles with Indian number plates.
Dhakal told reporters that the police got a tip off that Raj and his gang were smuggling weapons from India through the border.
Two Nepali nationals, Hafi Uhalla Musalman and Okil Musalman, were also arrested. The three of them were on the most wanted list and the police had been monitoring their activities for a month.