"So far, we have found four bodies. Two of them were wearing suicide vests and died in the blast and two others died when hit by police bullets," police's Chittagong Range Deputy Inspector General (DIG) Shafiqul Islam told reporters.
He said that three policemen have been injured after grenades were lobbed from inside.
The killed militants include a woman, police said.
The extremists, believed to be operatives of banned Neo-Jamaatul Mujahideen Bangladesh (JMB), hurled grenades and fired gunshots on security forces.
The encounter began after a night-long police siege to the hideout of the neo-JMB.
"Explosions rocked the neighbourhood for nearly 10 minutes," a journalist told PTI.
Police said the terrorists were living at the house in the guise of tenants.
"Twenty residents of the house including female and children of seven families came out of the building as the encounter ended," Counter-terrorism unit's deputy commissioner Abdul Mannan said.
Neo-JMB is said to be inclined to the Islamic State terror outfit which has claimed the responsibility for the deadly July 1, 2016 attack on a Dhaka cafe in which 22 people, including an Indian, were killed.
A police spokesman said the law enforcement agencies have launched countrywide "block raids" targeting presumed militant hideout since last Thursday. Eighty militants have been killed in these raids so far.
Bangladesh witnessed a spate of attacks on secular activists, foreigners and religious minorities since 2013.
The country launched a massive crackdown on militants specially after the Dhaka cafe attack.
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