The bomber and an Israeli soldier were killed. No children were hurt.

A caller to Israel Radio said the attack was carried out by the militant Islamic group Hamas.

The BBC's Jeremy Bowen: "It was a big bomb intended to cause terrible slaughter"

However, in a BBC interview Hamas leader Sheikh Ahmad Yassin declined to confirm or deny the claim.

Israel radio said a car attempted to draw up alongside the bus, but a military jeep escourting the bus managed to block its path, taking the brunt of the explosion.

In addition to the two deaths, six people were wounded in the blast. A Jewish settler then shot and wounded a Palestinian in the confusion that followed.

Arafat condemns attack

The Palestinian leader, Yasser Arafat, has condemned the attack, and expressed his sorrow.

Soldiers have sealed off the area

In a phonecall to the Israeli Prime Minister, Binyamin Netanyahu, he said he would do everything he could to find the bombers.

Mr Netanyahu says he replied by repeating that the land-for-security pact the two sides signed last week depended upon systematic action by the Palestinian authority to prevent such attacks.

Moshe Fogel: "If this attack succeeded ... we would not be able to go ahead with the peace process"

Israeli Government spokesman Moshe Fogel said if the attack had succeeded, it would have blocked the peace process.

"We can't go ahead with a peace process in which we have daily terrorist attacks against Israeli targets," he told the BBC.

He urged the Palestinians to do more to stop the violence.

"They can act against Hamas if they want to. They simply have not been doing what they have to do before a terrorist attack occurs. What they do is they act after the terrorist attack. That's simply not enough."

Israeli and Palestinian security forces are now reported to be co-operating in the investigation. An American representative, believed to be from the CIA, has also been at the scene.

Under the terms of the Washington peace agreement, the CIA is to help monitor security provisions.

{ Video 2} The BBC correspondent in Jerusalem, Lyse Doucet, says that the Palestinians know they have to improve security if they want Israel to hand over more land.

Israel handed over most of the Gaza Strip to Palestinian self-rule under peace deals dating back to 1993.

Some 6,500 Jews live in settler enclaves in the strip among more than a million Palestinians.