Quran 8:12-13 - I will instill terror into the hearts of the unbelievers

8:12-13... I will instill terror into the hearts of the unbelievers. Smite ye above their necks and smite all their finger tips off them. This because they contend against God and his apostle. ...

This is another ayah that is commonly quoted out of context, both historical context and the context of the ayah itself in the Qur'an. Let us first examine the full ayah: 

إِذْ يُوحِي رَ‌بُّكَ إِلَى الْمَلَائِكَةِ أَنِّي مَعَكُمْ فَثَبِّتُوا الَّذِينَ آمَنُوا ۚ سَأُلْقِي فِي قُلُوبِ الَّذِينَ كَفَرُ‌وا الرُّ‌عْبَ فَاضْرِ‌بُوا فَوْقَ الْأَعْنَاقِ وَاضْرِ‌بُوا مِنْهُمْ كُلَّ بَنَانٍ ﴿١٢﴾ ذَٰلِكَ بِأَنَّهُمْ شَاقُّوا اللَّـهَ وَرَ‌سُولَهُ ۚ وَمَن يُشَاقِقِ اللَّـهَ وَرَ‌سُولَهُ فَإِنَّ اللَّـهَ شَدِيدُ الْعِقَابِ ﴿١٣﴾

8:12-13 Recall that your Lord inspired the angels: "I am with you; so support those who believed. I will throw terror into the hearts of those who disbelieved. You may strike them above the necks, and you may strike even every finger." This is what they have justly incurred by FIGHTING God and His messenger. For those who fight against God and His messenger, God's retribution is severe.

That is the context of the ayah in the Qur'an. The historical context is that this verse was revealed at the Battle of Badr, a battle in which the pagans of Makkah traveled over 200 miles to destroy the Muslims of Madinah. The Pagans of Makkah had an army of about 1000 while the Muslims were only 300 followers. The Prophet Muhammad ((peace be upon him)) and his followers had suffered severe persecutions and torture for 13 years in the city of Makkah. Having fled from Makkah to the safety of Madinah, they found that they were once again threatened. Abul 'Ala Maududi describes the situation that led to the Battle of Badr, beginning with the Muslim activity in Madinah:

In the first year of Hijrah, four expeditions were sent [by the Muslims to the Quraish], that is, the expedition under Hamzah, the expedition under Ubaidah bin Harith, the expedition under Sa'ad bin Abi Waqqas and the Al-Abwa' expedition under the Holy Prophet himself. In the first month of the second year two more incursions were made on the same route. These are known as Buwat Expedition and Zawal Ushairah Expedition. Two things about all these expeditions are noteworthy. First, no blood was shed and no caravans were plundered in any of these expeditions. This proves that the real object of these expeditions was to show to the Quraish which way the wind was blowing. Secondly, not a single man from the people of Al-Madinah was sent by the Holy. Prophet on any of these incursions. All the bands consisted purely of the immigrants from Makkah so that the conflict should remain between the people of the Quraish themselves and should not further spread by the involvement of other clans. On the other side, the Quraish of Makkah tried to involve others also in the conflict. When they sent bands towards Al-Madinah, they did not hesitate to plunder the people. For instance, an expedition under the leadership of Kurz bin Jabir al-Fihrl plundered the cattle of the people of Al-Madinah from the very vicinity of the city to show what their real intentions were. This was the state of affairs when, in Sha'aban, 2 A. H. (February or March, 623 A. D.) a big trade caravan of the Quraish, carrying goods worth $50,000 or so, with only a guard of thirty to forty men, on its way back from Syria to Makkah, reached the territory from where it could be easily attacked from Al-Madinah. As the caravan was carrying trade goods worth thousands of pounds, and was scantily guarded, naturally Abu Sufyan, who was in charge of it, from his Past experience feared an attack from the Muslims. Accordingly, as soon as he entered the dangerous territory, he despatched a camel rider to Makkah with a frantic appeal for help. When the rider reached Makkah, he, following an old custom of Arabia, tore open the ears of his camel, cut open his nose and overturned the saddle. Then rending his shirt from front and behind, he began to cry aloud at the top of his voice, "O people of Quraish despatch help to protect your caravan from Syria under the charge of Abu Sufyan, for Muhammad with his followers is in pursuit of it; otherwise I don't think you will ever get your goods. Run, run for help." This caused great excitement and anger in the whole of Makkah and all the big chiefs of the Quraish got ready for war. An army, consisting of 600 armored soldiers and cavalry of 100 riders with great pomp and show marched out for a fight. They intended not only to rescue the caravan but also to put to an end, once for all, the new menace from the Muslims who had consolidated themselves at Al-Madinah. They wanted to crush that rising power and overawe the clans surrounding the route so as to make it absolutely secure for future trade... ...the Holy Prophet and the true Believers had realized the urgency of that critical hour which required the risk of life: therefore they marched straight to the south-west, wherefrom the army of the Quraish was coming. This is a clear proof of the fact that from the very beginning they had gone out to fight with the army and not to plunder the caravan. For if they had aimed at plundering the caravan they would have taken the north- westerly direction and not the south- westerly one. (Maududi, Tafheem Al-Qur'an, emphasis added)

The Makkans were not satisfied with expelling the Muslims from Makkah and subsequently desired that they be purged from the surroundings of all major trade routes. So God supported the Muslims and informed them that God would allow justice to prevail over oppression. He informed them that they should not fear fighting in God's path, but it is the enemies who should fear God's retribution for their oppression and injustice. Also, God inspired the ANGELS to support the believers and strike the disbelievers. This was NOT a command for the Muslims. Shaykh Safiur Rahman Al-Mubarakpuri describes the situation during the Battle of Badr as follows:

[The Makkans] were too much exasperated and enraged and fell upon the Muslims to exterminate them once and for all. The Muslims, however, after supplicating their Lord, calling upon Him for assistance, were made to hold to their position and conduct a defensive war plan that was successful enough to inflict heavy losses on the attackers. The Prophet (Peace be upon him) used to pray to his Lord ceaselessly persistently and day and night to come to their succour. When the fierce engagement grew too hot he again began to supplicate his Lord saying: “O Allâh! Should this group (of Muslims) be defeated today, You will no longer be worshipped.”.... Immediate was the response from Allâh, Who sent down angels from the heavens for the help and assistance of the Prophet (Peace be upon him) and his companions. The Noble Qur’ân observes: And recall when your Lord inspired the angels: “Verily, I am with you, so keep firm those who have believed. I will cast terror into the hearts of those who have disbelieved.” [8:12]
(Al-Mubarakpuri, Ar-Raheeq Al-Makhtum; Riyadh-Saudi Arabia, Dar-us-Salam Publications, 1996; pp. 219-220)

Also, the previously mentioned laws of Jihad all applied here and the Muslims were commanded:

8:61 But if the enemy incline towards peace, do thou (also) incline towards peace, and trust in God: for He is One that hears and knows (all things).

وَإِن جَنَحُوا لِلسَّلْمِ فَاجْنَحْ لَهَا وَتَوَكَّلْ عَلَى اللَّـهِ ۚ إِنَّهُ هُوَ السَّمِيعُ الْعَلِيمُ ﴿٦١﴾

Believing in a punishment for oppressive disbelievers delivered by the unseen angels is hardly different from believing in an unseen punishment in the next life.