Two Pakistani soldiers were killed and eight wounded, Dr Mutahir Shah said at Islamabad's main hospital.
Major-General Waheed Arshad, a military spokesman, said security forces launched an operation at 4am (2300 GMT on Monday) "to clear the madrasa of militants".
"The militants are using small arms and grenades. They are in the basement, we have covered the rooftop," he said, adding that the operation was expected to take three or four hours.
Failed talks
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"I would not say that they are following the teachings of the Prophet, but the warped version of their warped clerics"
Chris, Stockholm, Sweden
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Chaudhry Shujaat Hussain, a former prime minister and ruling party leader who spearheaded last-minute negotiations, said last ditch efforts to secure a peaceful solution had failed.
"I am returning very disappointed," he said.
Al Jazeera's Kamal Hyder said Pakistani officials had been hoping for a peaceful end to the seven-day standoff at the Islamabad mosque after negotiators offered religious leaders inside a deal.
The deal was believed to have been arranged after Hussain met Pervez Musharraf, Pakistan's president.
Hyder said Hussain had gone back to the mosque with an offer of safe passage, one of the demands of Abdul Rashid Ghazi, the mosque's deputy leader.
Security forces had previously held back from mounting a full-scale assault because of fears for the safety of women and children that they said were being held hostage by Ghazi.
Ghazi said he had nearly 2,000 followers with him and that no one was being held hostage.