Rebels ambushed a police truck with a bomb and gunfire on Saturday, also hitting a nearby passenger bus in an attack that killed 14 policemen and four civilians, including at least one child.
At least 27 people were wounded in the attack in the village of Dhankhola, about 400km southwest of Nepal's capital, Katmandu.
The police truck was on patrol when it hit a mine in the road, and the rebels opened fire, police officials said. Surviving police fired back.
A passenger bus traveling right behind the police vehicle was caught in the crossfire, and at least four civilians were killed, police said.
The battle lasted for about two hours before reinforcements reached the area. The rebels fled after government soldiers fired from army helicopters.
Police and hospital officials said 14 civilians and 13 police were wounded in the attack. Most were taken to a hospital in Nepalgunj, the nearest big town in the area.
Doctors said most of those hospitalized have bullet wounds.
"I saw some people with guns on the hills and yelled at the driver but the explosion hit the police truck, and the rebels began firing indiscriminately. Many passengers were hit," Ramesh Shah, a wounded passenger, told reporters from his hospital bed.
Nirmala Baral's 2-year-old son was killed in the attack.
"I was holding my son on my lap. A bullet pierced through the windshield and hit my son on the head ... He died on my lap," Baral said. Her husband and 3-year-old daughter were wounded."
It wasn't immediately clear if there were any rebel causalities. Army troops have sealed the highway and were hunting for the attackers in the surrounding jungles.
Fighting between the rebels, who say they are inspired by Chinese revolutionary leader Mao Zedong, and government forces has escalated since the guerrillas withdrew from a seven-month cease-fire last August.
The rebels have been fighting since February 1996 to replace Nepal's monarchy with a communist state.
The insurgency has claimed more than 9,500 lives.