The hostage and a policeman sustained injuries during the rescue operation, they added.
Jammu and Kashmir Director General of Police (DGP) has announced a cash reward of Rs 50,000 for the rescue party.
Giving details, DIG, Baramulla, Dr B Srinivas said police received specific information that a shopkeeper from Srinagar was abducted by militants in Lolab valley during his visit to Kupwara for business purposes.
He said four Pakistani militants of the Harkat-ul-Mujahideen outfit had abducted him from Lolab and taken to Rangwar forest area.
They had later made a call to the relatives, demanding a ransom of Rs five lakh for setting him free, Dr Srinivas added.
Acting on this information, he said a decoy team was sent to pay the ransom and rescue the abducted businessman.
During the preceding night, the militants asked the decoy party to reach an identified location in Rangwar, the DIG said, adding a police party of eight men and back up reinforcement by the CRPF then moved into the jungle area.
As soon as the police reached the location, one of the militants opened fire on them which was effectively retaliated.
During the exchange of fire, the police party managed to rescue the abducted businessman from the clutches of the militants.
In the gunfight and the rescue operation, Dr Srinivas further said that one of the policemen, Noor-ul-Almas, received bullet injuries on his head while the hostage also sustained a bullet wound in his shoulder. They have been hospitalised.
During the gun-battle, one of the militants was also wounded, but all of them managed to escape as the police personnel were busy rescuing and evacuating the hostage, he added.
In appreciation of this brave action, the DGP announced a cash reward Rs 50,000 for the police party.