The armed men entered the church in Saint-Etienne-du-Rouvray during Mass, taking the priest and four other people hostage, the interior ministry said.
French TV said shots had been heard after police arrived at the scene. Both hostage-takers are now dead.
The area has been cordoned off and police have told people to stay away.
French interior ministry spokesman, Pierre-Henri Brandet, said one of the hostages had been critically wounded.
He said the hostage-takers had been "neutralised" after coming out of the church. Police were now searching the church for explosives.
'Barbaric'
Mr Brandet said the motive of the attackers was not immediately clear, but the investigation into the incident would be led by anti-terrorism prosecutors.French Prime Minister Manuel Valls has expressed his horror at the "barbaric attack".
"The whole of France and all Catholics are wounded. We will stand together," he wrote on Twitter.
President Francois Hollande and Interior Minister Bernard Cazeneuve are on their way to Saint-Etienne-du-Rouvray to be briefed by police.
A woman who works at a local beauty parlour, Eulalie Garcia, said she had known the 92-year-old priest since her childhood.
"My family has lived here for 35 years and we have always known him," she said.
"He was someone who was treasured by the community. He was very discreet and didn't like to draw attention to himself."
There was no immediate word on the identity of the hostage-takers, but France has been on high alert since the Bastille Day attack in Nice earlier this month, when a man ploughed a lorry into celebrating crowds, killing more than 80 people.
The Nice attack was carried out by Tunisian Mohamed Lahouaiej-Bouhlel, who was not a known jihadist but so-called Islamic State said he had acted in response to its calls to target civilians in countries that have been attacking it.
The BBC's Lucy Williamson in Paris says the French government has been under huge pressure to prevent further attacks.
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