Local police official Waheed Khan said the explosion occurred as worshippers had collected in the Kucha Risaldar mosque in Peshawar's old city for Friday prayers.
Ambulances rushed through congested narrow streets carrying the wounded to Lady Reading Hospital.
Peshawar police Chief Muhammed Ejaz Khan said the violence started when two armed attackers opened fire on police outside the mosque.
One attacker and one policeman were killed in the gunfight, and another police official was wounded. The remaining attacker then ran inside the mosque and detonated a bomb.
At least 150 worshippers were inside the mosque at the time of the explosion.
No one immediately claimed responsibility for the blast, but both the Islamic State group and a violent Pakistani Taliban organisation have carried out similar attacks in the region, located near the border with neighbouring Afghanistan.
Shayan Haider, a witness, had been preparing to enter the mosque when a powerful explosion threw him to the street.
"I opened my eyes and there was dust and bodies everywhere," he said.
At the Lady Reading Hospital Emergency department, there was chaos as doctors struggled to move the many wounded into operating theatres.
Hundreds of relatives gathered outside the emergency department, many of them wailing and beating their chests, pleading for information about their loved ones.
Prime Minister Imran Khan condemned the bombing.
Retired army officer Sher Ali who had been inside the mosque at the time of the explosion was injured by flying shrapnel. He made a impassioned plea to the Pakistani government for better protection of the country's minority Shi'Ite Muslims.
"What is our sin? What have we done? Aren't we citizens of this country?" he said from within the emergency department, his white clothes splattered with blood.
In majority Sunni Muslim Pakistan, minority Shi'Ite Muslims have come under repeated attacks.
In recent months Pakistan has experienced a broad increase of violence. Dozens of military personnel have been killed in scores of attacks on army outposts along the border with Afghanistan.
Much has been claimed by the Pakistani Taliban, which analysts say have been emboldened by the Afghan Taliban's return to power in August.
Pakistan has urged Afghanistan's new rulers to handover Pakistani Taliban insurgents who have been staging their attacks from Afghanistan.
Afghanistan's Taliban say their territory will not be used to stage attacks against anyone, but until now they have not handed over any Pakistani insurgents.
