North Korea said it would not react to "reckless" military drills by the South on Monday, despite an earlier threat to retaliate, and CNN reported that Pyongyang had agreed to the return of nuclear inspectors.
Air-raid bunkers on the South Korean island of Yeonpyeong shook during the live-fire artillery exercise, which went on for just over 90 minutes, but the North Korean guns that had shelled the island after a similar drill last month stayed silent.
"The revolutionary armed forces of the DPRK did not feel any need to retaliate against every despicable military provocation," the official KCNA news agency said, quoting a communique from the North's Korean People's Army Supreme Command that dismissed the drills as a "childish play with fire".
The U.N. Security Council was deadlocked in its efforts to ease tensions on the divided peninsula, but the lack of North Korean response and the nuclear offer reportedly made to U.S. troubleshooter Bill Richardson offered some breathing space.
"The situation is very tense," Russian Foreign Minister Sergei Lavrov told reporters in Moscow. "There can be no optimism in this situation."
South Korean financial markets took the day's events in their stride, recovering from early falls, but international investors remained concerned, with the cost of insuring South Korean sovereign debt for five years rising 10 percent.
The mercurial North had threatened it would strike back if its neighbour went ahead with the live-fire exercise.
On Nov. 23, North Korean artillery had shelled Yeonpyeong, close to the disputed maritime border off the west coast of the Korean peninsula, killing four people, in the worst attack on South Korean territory since the Korean war ended in 1953.
"It's a perfectly natural thing for a sovereign nation and a divided country to conduct military exercises to defend its territory in the face of military conflict," South Korean President Lee Myung-bak said in a statement.
Monday's artillery exercise came hours after a U.N. Security Council meeting on the Korean peninsula crisis ended in an impasse, with Russia and China resisting an explicit condemnation of the North for last month's attack.
China's foreign ministry responded to the drills with a statement that said: "We strongly call for the relevant parties to maintain the greatest degree of restraint and adopt a responsible attitude to prevent the deterioration and escalation of the situation."
But amid the diplomatic gloom, New Mexico Governor Richardson, visiting Pyongyang to try to ease tension, won agreement from North Korea to allow U.N. nuclear inspectors to return, according to CNN, which has a team travelling with him.
Pyongyang "agreed to allow International Atomic Energy Agency personnel to return to a nuclear facility in the country and agreed to negotiate the sale of 12,000 ... fuel rods and ship them to an outside country, presumably to South Korea", CNN said, quoting correspondent Wolf Blitzer in Pyongyang.
The South Korean Foreign Ministry said it could not confirm the agreement.
"We do not have the specific details yet, so it is too early to make an official evaluation," a spokesman said.
Richardson was visiting in an unofficial capacity, the traditional means of communication between the two sides, but it was unclear whether the reported agreement meant real progress, particularly given Pyongyang's poor record of honouring deals.
North Korea expelled inspectors in April 2009 after ripping up a previous disarmament-for-aid agreement.
"It means that they are prepared to give up, at least in part, the plutonium programme, which has been the source of the fuel rods they came up with," said North Korea expert Kim Yong-hyun of Dongguk University. "It would be considerable progress, if true."
However, North Korea last month unveiled major technical progress in uranium enrichment, suggesting another reason it could be willing to end the plutonium programme.
"There is obviously a large element of gamesmanship in North Koreans reported offer," said Mark FitzPatrick, a nuclear expert at the International Institute for Strategic Studies.
"It's a way to entice the U.S. and its allies to return to six-party talks, to discuss what the North Koreans would expect in exchange for these offers."
In Vienna, the International Atomic Energy Agency (IAEA) had no immediate comment.
"The question is: what would the IAEA be asked to do?" said a diplomatic source, adding that one possibility was that North Korean wanted the IAEA to "tell the world" about its uranium enrichment programme.
Tension ahead of the military drills initially hit Korean markets when they opened on Monday, with the won falling nearly 2 percent to a four-week low against the dollar and stocks also down 1 percent in early trade.
But shares recouped most of their losses to close down just 0.3 percent, slightly outperforming the region as a whole, while the won ended local trade higher against the dollar.
Sunday's announcement that Seoul would impose a levy on the foreign debt of banks from late 2011 also weighed on markets. The move was Seoul's latest attempt to discourage too much speculative hot money flowing into South Korean assets, a reminder that local markets are bullish despite the tension.
Both sides have said they will use force to defend what they say is their territory off the west coast, raising international concern that the standoff could quickly spiral out of control.
Five-year credit default swaps for South Korean sovereign debt rose 9 basis points to 100 bps.
Russia had called Sunday's emergency Security Council meeting to try to prevent an escalation, but major powers failed to agree on a draft statement because of differences over whether to lay the blame on Pyongyang.
"The gaps that remain are unlikely to be bridged," said Susan Rice, the U.S. ambassador to the United Nations.
Other diplomats, however, said it was possible the Council could return to the issue as early as Monday.
Western diplomats said China and Russia were pushing for an ambiguous statement that would not have blamed North Korea for the crisis, but would have called on both sides to exercise restraint. Rice said the "vast majority" of council members did not want an ambiguous statement.