BBC's correspondent Kylie Morris in Gaza says the clearing operation was the fourth in the past few months, and the ensuing battle was one of the fiercest at the flashpoint since a US-brokered ceasefire was announced three weeks ago.
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The clash followed a suicide mission in Gaza on Monday in which only the Palestinian bomber, a member of the militant Hamas movement, was killed.
Tensions have been running high in the town since an 11-year-old Palestinian boy was shot dead by Israeli soldiers on Saturday.
General Abdel Rajak el-Majiada, a Palestinian security official, described the overnight house demolitions as a savage attack, and said it aimed only to terrorise innocent residents.
An Israeli security post overlooks the gate at the border and regularly comes under attack from stone throwers and gunmen.
Jerusalem houses demolished
On Monday, Israeli bulldozers, backed by hundreds of policemen, levelled 14 houses under construction in the refugee camp of Shuafat, on the northern edge of Jerusalem.
The demolition provoked clashes between protestors and Israeli police.
Israel said the homes, still under construction and uninhabited, were demolished because they were built without permits.
The houses were being built "lawlessly on public land, on pathways, on green areas, on areas that do not belong to them," Jerusalem Mayor Ehud Olmert told Israel radio. "It is a total violation of the law."
But Palestinians say permits are practically impossible to obtain and the demolitions are part of Israel's effort to restrict the growth of Palestinian population in and around Jerusalem.
The United States has criticised both sides for the bloodshed and State Department spokesman Richard Boucher told a news briefing: "We're deeply troubled over the upsurge...in violence over the weekend."
Divisions in Israel
Following the Gaza suicide attack and the death of an Israeli officer on Monday from injuries sustained in a West Bank bomb explosion, divisions emerged in the Israeli government over whether the Palestinians were doing enough to stop the violence.
Israeli Prime Minister Ariel Sharon and many of his Cabinet ministers have harshly criticised Palestinian leader Yasser Arafat for failing to rein in militants.
The Haaretz newspaper said left-wing Foreign Minister Shimon Peres and Mr Sharon disagreed over when Israel should begin implementing measures under a peace plan that calls for a halt to Jewish settlement building and a lifting of the blockade on the Palestinians.
So far 641 people have been killed since the beginning of the Palestinian uprising, or intifada, in September. Almost 30 have been killed since the truce mediated by CIA chief George Tenet came into effect on June 13.
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