Xinjiang police raided the suspects' apartment in Urumqi Tuesday, killing five of its members, reported Xinhua, the official Chinese news agency. Two people were injured and eight were arrested.
The 15-member group allegedly flashed knives and threatened to "perish together" when confronted by police, a spokesman with the city's public security bureau said.
Police raided the apartment to search for three men following a stabbing at a Urumqi beauty salon in May, Xinhua said.
After firing tear gas into the unit, several people armed with knives tried to escape, injuring one police officer, the spokesman said.
"The policemen were then forced to open fire, killing five on the spot and injuring two," he said. The eight others were taken into custody and more than 30 knives were recovered.
The suspects said they trained to initiate a "holy war" against Han people -- the largest ethnic group in China -- whom they considered heretics, then found their own state, the spokesman told Xinhua Wednesday.