We present XMM-Newton observations of gamma^2 Velorum (WR 11, WC8+O7.5III, P = 78.53 d), a nearby Wolf-Ray binary system, at its X-ray high and low states. At high state, emission from a hot collisional plasma dominates from about 1 to 8 keV. At low state, photons between 1 and 4 keV are absorbed. The hot plasma is identified with the shock zone between the winds of the primary Wolf-Rayet star and the secondary O giant. The absorption at low state is interpreted as photoelectric absorption in the Wolf-Rayet wind. This absorption allows us to measure the absorbing column density and to derive a mass loss rate 8x10^{-6} M_sun/yr for the WC8 star. This mass loss rate, in conjunction with a previous Wolf-Rayet wind model, provides evidence for a clumped WR wind. A clumping factor of 16 is required. The X-ray spectra below 1 keV (12 Ang) show no absorption and are essentially similar in both states. There is a rather clear separation in that emission from a plasma hotter than 5 MK is heavily absorbed in low state while the cooler plasma is not. This cool plasma must come from a much more extended region than the hot material. The Neon abundance in the X-ray emitting material is 2.5 times the solar value. The unexpected detection of CV (25.3 Ang) and CVI (31.6 Ang) radiative recombination continua at both phases indicates the presence of a cool (~40,000 K) recombination region located far out in the binary system.