The Sinhalese are a mainly Buddhist ethnic group making up almost three-quarters of Sri Lanka's 21 million people, while Muslims are just 10 per cent of the country's population.
The attack took place following the death of a Sinhalese youth who had allegedly been assaulted by a Muslim mob, a police officer who declined to be named told Reuters.
Rajith Keerthi Tennakoon, executive director at Centre for Human Rights and Research, a non-government organisation, said "police inaction to control the mob from arson attacks was a surprise, and police should take all steps to prevent the spread of ethnic clashes in the area".
Sri Lanka has always been divided between the majority Sinhalese, who are overwhelmingly Buddhist, and minority Tamils who are Hindu, Muslim and Christian.
Schools were shut across Kandy, a hill station popular with tourists, as rioters defied curfews and clashed with police who used teargas to disperse the mobs.
Some of the violence has been instigated by Facebook postings that threatened more attacks on Muslims, the government said.
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Several houses and business establishments in the district, belonging to minority Muslim community, were burnt on Monday while the body of a young man was found inside a burnt house today.
"We have clear rules against hate speech and incitement to violence and work hard to keep it off our platform", the social network said in a statement.
Prime Minister Ranil Wickremesinghe told parliament that "political groups" he did not identify were trying to incite hatred against Muslims.
His successor President Maithripala Sirisena was elected in 2015 promising an end to draconian government restrictions, but some websites critical of the government remain blocked.
Police and some residents said Sinhalese owned properties were also attacked.
Religious and ethnic violence can turn deadly in Sri Lanka, where Muslims account for 10 percent of the population and Sinhalese make up almost 75 percent. After the Tamil rebels were crushed in a military offensive in 2009, the Emergency was finally lifted in August 2011.
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"As a nation that endured a brutal war we are all aware of the values of peace, respect, unity and freedom", he said on Twitter.
"While it is positive that the government wishes to prevent further violence, any steps taken to address the problem, however, must meet Sri Lanka's obligations under worldwide human rights law, including the absolute prohibition on torture, unfair trials and arbitrary detention", said Biraj Patnaik, the group's South Asia director.
The U.S. State Department issued a security alert warning of the possibility of further unrest in Kandy.
"There are many good Sinhalese people", he said.
Denmark and Norway warned their citizens in Sri Lanka about the state of emergency, saying they should be "cautious, stay away from large crowds and demonstrations, follow media and listen to advice from local authorities".
Sri Lanka is the world's third biggest tea exporter.
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Police would not release the names of the men, who were in custody Thursday morning pending charges, a spokeswoman told CNN. In the video, people can also be heard yelling " f**k the blacks " and "blacks and whites will never live together".