Mohinder Singh, a herbal medicines' seller, was kidnapped from his shop in Tabbai village of Khyber tribal agency by unidentified armed men on November 20.
He was beheaded on Tuesday and his body was mutilated before it was packed in a sack and dumped at Zakhakhel Bazaar in Khyber, unnamed officials were quoted as saying by the Dawn newspaper.
The officials said that Tawheedul Islam militant group had claimed responsibility for killing Singh.
A note left with the body said Singh had been killed for "spying" for rival militant group, the Lashkar-e-Islam. The body was identified by the slain man's brother Daswant Singh.
He said his brother's killing was a "cruel act" against members of the minority Sikh community.
"We have no enmity with anyone and have lived peacefully in Khyber agency for more than six decades," he said.
Daswant told The News daily that his family had earlier approached the Tauheedul Islam, a pro-government militia of Zakhakhel tribesmen, but it had claimed it did not know the whereabouts of Singh.
"After we tried and used all tribal channels and sources for the recovery of my brother, we sent an application to Mutahir Zeb, Political Agent of the Khyber Agency, on December 13 to seek his support," Daswant said.
The official had reportedly assured the family that Singh would be recovered within a week.
Daswant said his brother, a diabetic, has been survived by his wife and nine children, including a polio-affected son.
He demanded that the government should protect minorities and pay compensation to the family.