Nanocomposite films containing Ag nanoparticles embedded in partially oxidized amorphous Si matrix were deposited on silica glass substrates by co-sputtering of Ag and Si with 1.5 keV neutral Ar atoms. The Ag content and thickness of the nanocomposite films was determined by Rutherford backscattering spectrometry. Optical absorption studies revealed the presence of surface plasmon resonance (SPR) indicating the formation of Ag nanoparticles in the as-deposited films. The position, width and strength of SPR have been found to be strongly dependent on the Ag content of the films. For annealing in oxidizing atmosphere, a significant red shift in the SPR along with a drastic reduction in the resonant absorption has been observed. The amount of red shift has been found to be dependent on the Ag content of the films. Transmission electron microscopy was used to study the size distribution, shape and crystal structure of Ag nanoparticles in the nanocomposite films. TEM analysis of annealed sample revealed the formation of silver oxide nanoshells surrounding Ag nanoparticles.