The event in the city of Highland Park was suddenly halted shortly after 10:00 local (15:00 GMT), when several shots were heard.
Residents have been urged to stay at home and contact their loved ones to make sure they are safe.
City authorities said 24 people had also been hospitalised.
"We are aggressively looking for the individual responsible for this shooting," Lake County Major Crime Task Force spokesman Christopher Covelli told reporters.
Police have described the suspect as a white man, aged 18-20, who is "armed and dangerous" and appeared to have targeted the parade's attendees at random with a high-powered rifle.
More than six hours later law enforcement officers were still searching for him, centring their investigation on the parade route, the downtown area and the central business district.
Those living in these areas, described by police as an "active crime scene", were advised to continue sheltering in place.
Nearby suburbs have also gone on lockdown, with beaches evacuated and local parades and fireworks shows cancelled.
The suspected shooter opened fire at the parade at around 10:15 local time (15:15 GMT), just a few minutes after it began. The event was scheduled to include floats, marching bands, and community entertainment as part of the city's Independence Day celebrations.
But what should have been one of the happiest days of the year quickly turned to panic, with pushchairs, purses and lawn chairs left discarded on the street as crowds fled from the scene.
The suspect is believed to have fired at members of the public from the rooftop of a nearby shop, where police say they recovered "evidence of a firearm."
"On a day that we came together to celebrate community and freedom, we're instead mourning the tragic loss of life," said city mayor Nancy Rotering.
The Fourth of July is a national holiday marking the date the American colonies declared independence from Great Britain in 1776.
Witnesses at the scene described the terrifying moment they heard multiple shots fired in quick succession.
Anand, who said he was less than 100m (328ft) from the shooter, told the BBC he initially thought he had heard a car backfiring before he saw others running and realised what was unfolding.
It was "the type of gun where it releases a lot of bullets in a very short amount of time. Incredibly loud. Then there's complete silence," he said.
Gun violence is very rare in this suburban area, he added: "I felt so safe here and this is very surreal. We're hiding in a shelter now keeping safe, there's people crying. It's not a good feeling, at all."
Another witness, Noel Hara, described how he was having breakfast at Starbucks after dropping off his son at the parade, when the chaos unfolded.
"About 30 people suddenly came rushing in screaming and we were locked into the Starbucks bathroom," Mr Hara told the BBC.
"Moments later, they evacuated us from the Starbucks because they thought the shooter was trying to get in the back door."
Mr Hara was eventually able to reunite with his son after following his movements on a location tracking app.
Gun violence in Chicago tends to rise over holiday weekends as the hot weather sends people outdoors. In 2021, more than 100 people were shot and 17 killed over the Fourth of July weekend in the city of Chicago.
The shooting comes just a month after the deadly shootings in Uvalde, Texas and Buffalo, New York - and a week after the US Congress passed bipartisan legislation on gun control in America.