THIMPHU – India and Pakistan's leaders were due to meet Wednesday at a regional summit in Bhutan, but a spy scandal dented already slim hopes that they might find a way back to substantive peace talks.

On Tuesday on the eve of Indian Prime Minister Manmohan Singh's departure for the summit, officials in New Delhi said that an Indian diplomat working at their embassy in Islamabad had been arrested on suspicion of passing secrets to Pakistani intelligence services.

The incident is likely to further sour the atmosphere between the two nations ahead of a possible one-on-one meeting between Singh and Pakistani counterpart Yousuf Raza Gilani in the Bhutanese capital Thimphu.

The two prime ministers will attend the opening Wednesday afternoon of the 16th summit of the eight-nation South Asian Association for Regional Cooperation (SAARC).

Indian officials had floated the prospect of a two-way meeting on the sidelines to discuss a long-running water dispute, but Pakistan has made it clear that it wants a formal, open-ended dialogue.

"It's time for India to make up its mind whether it wants to engage or not.... Engagement is the only way forward," Pakistani Foreign Minister Shah Mahmood Qureshi told the Indian CNN-IBN TV channel on Tuesday.

"We need to go beyond a handshake," Qureshi said, referring to Singh and Gilani's cursory exchange of pleasantries at a 47-nation summit on nuclear security in Washington earlier this month.

India broke off all dialogue with Pakistan after the 2008 Mumbai attacks, which killed at least 166 people and were blamed by New Delhi on Pakistan-based militants.

Contact was tentatively resumed at a meeting of top foreign ministry officials in Delhi in February, but India insisted the resumption of proper dialogue depended on Pakistan bringing to justice those responsible for the Mumbai carnage.

Qureshi said it was time for India to move forward and stop demonising Pakistan.

"We have to accept terrorism is a common challenge. It's not us and you, it's a collective effort," he said.

Qureshi attended a meeting of SAARC foreign ministers Tuesday along with Indian counterpart S.M. Krishna, but the latter refused to even confirm that Singh and Gilani would meet separately. "Let's wait until the prime minister comes," he told reporters.

During the foreign ministers' gathering, Krishna called for all SAARC nations to "rally against the forces of terrorism".

"The South Asian region is particularly afflicted by this menace," he said, without mentioning Pakistan by name.

SAARC groups Afghanistan, Bangladesh, Bhutan, India, the Maldives, Nepal, Pakistan and Sri Lanka and was formed in 1985 to boost development and raise the living standards of poverty-stricken people in a region home to a fifth of humanity.

But 25 years and 15 summits later, it has achieved very little, largely due to the volatile relationship between nuclear-armed India and Pakistan, say critics.

The bitter rivals have fought three wars since the subcontinent's 1947 partition and remain at loggerheads over the region of Kashmir.

They are also locked in a struggle for influence in Afghanistan, which joined SAARC in 2007, adding a conflict involving the United States to the group's headaches.

The spying scandal that erupted Tuesday involves a 53-year-old junior diplomat working in the information service of the Indian embassy in Islamabad.

The woman, Madhuri Gupta, a second secretary in the embassy, was arrested for breaching the official secrets act, which carries a minimum 10-year jail term, a senior police source told AFP. The source said she had been under surveillance for six months.

For SAARC's smaller members, the India-Pakistan dynamic gets in the way of their efforts to leverage the group's potential in other areas, including trade, development, water-sharing and environmental controls.

Bhutan is hosting the summit for the very first time and the tiny Himalayan kingdom wants to focus on climate change.

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