The Indian government has rejected its inclusion on a list of countries compiled by the US which have not fully stopped human trafficking. India was designated as a "Tier 2" country: it did not fully comply with minimum standards but was making significant efforts to do so.
The government says a lot is being done to tackle the problem, although more needs to be done.
It says efforts are underway to rescue and rehabilitate trafficking victims.
Sanctions possibility "The world's largest democracy has the world's largest problem of human trafficking," said the US state department's specialist on trafficking issue, Mark Lagon.
The department has warned India would be downgraded to a "Tier 3" category unless it improved its track record. That would mean that the US would withhold non-humanitarian, non-trade related foreign aid.
The US wants countries to address the trafficking problem Correspondents say that "Tier 3" countries are also denied access to educational and cultural exchange programmes. The state department estimates that around 800,000 people are trafficked across international borders every year, and that 80% of them are females used in the sex trade.
The annual report places India as a "Tier two" country for the fourth year in a row.
An official in India's Women and Child Development ministry, however, defended her department's efforts in tackling the problem.
'Unfair' "We are doing our bit, but more needs to be done," said Deepa Jain Singh, secretary for the Women and Children's Development Ministry. Non governmental organisations (NGOs) working in the area have supported the government's efforts.
"We don't agree that nothing has changed. Legislation has come in place to deal with the issue. It is a clear indication that the pressure on the government is working," Rishi Kant, from the women's group, Shakti Vahini, told the BBC News website.
India has been warned it may face sanctions Other women's groups argued that it was unfair that India was being put on the US watch list over the issue, and not Bangladesh or Nepal.
Aid agencies estimate that around 5,000 to 7,000 women and girls are trafficked to India from Nepal and around 10,000 to 20,000 women and children from Bangladesh.
"Nepal, Bangladesh and India need to work together to stop such trafficking," United Nations Development Programme spokeswoman Archana Tamang told the BBC.
"Women and children are not being brought into India only, there is a lot of reverse trafficking taking place as well.
"It is really important for all the three nations to work together as a sub-regional group to remedy the situation," she said.