The head of the international observers, William Walker, told the BBC he was due to start peace negotiations in Podujevo - the centre of the conflict.

BBC Correspondent Paul Welsh: Observers believe both sides are to blame

He was speaking after the Kosovo Liberation Army abandoned its ceasefire in response to the Christmas Eve attack which involved around 100 Yugoslav army tanks.

Ethnic Albanian sources said at least nine people including a girl of six had been killed during the shelling in the north of the province.

A KLA spokesman told the BBC they were willing to re-establish the ceasefire, but also called on the West to carry out strikes against the Serbs.

Earlier, Mr Walker blamed both parties for escalating the violence which has left the fragile peace on the verge of collapse and revived the threat of Nato strikes.

''Both sides have been looking for trouble and found it,'' he added.

Mr Walker said his unarmed mission run by the Organisation for Security and Cooperation in Europe was the best chance of peace.

But he revealed his monitors had been turned back at gunpoint by Serb forces during the violence - which he said was a clear breach of United Nations resolutions.

Mr Walker's comments were echoed by the US which condemned the Serbian offensive, but also criticised what it called "provocative acts'' by KLA elements.

Nato warning

Nato Secretary-General Javier Solana said Nato's activation order on Yugoslavia remained in force, allowing military operations against Yugoslavia if the situation deteriorated.

The BBC's Paul Wood: KLA sources say civilians have been fired on

Mr Solana described the KLA's cancellation of its ceasefire as "a tremendous mistake".

But he warned that Yugoslav President Slobodan Milosevic must keep to his promises regarding the deployment of soldiers and police in the province.

"I would like to ... make a clear appeal to both sides to comply with ceasefire that they had agreed and continue towards the only solution ... which is the political solution," he added.

But in Belgrade, Serbia's ultra-nationalist vice premier, Vojislav Seselj, said the police ''must continue to clamp down against the terrorists".

'We liquidated terrorists'

Serbian authorities described Thursday's operation as a "limited-scale search" for suspects in the killing of a policeman.

Javier Solana: Activation order still in place

Serb police said they encountered "fierce fire" but "liquidated" several "terrorists" in the rebel stronghold of Lapastica.

Ethnic Albanian sources said the Serbs had torched houses, civilians had come under fire and scores of refugees had fled into the mountains.

KLA counterstrike

OSCE spokesman Jurgen Grunnet: There are reports of shelling and machine gun fire

Rebel fighters said they had destroyed seven tanks and 12 armoured vehicles and inflicted numerous casualties.

A BBC correspondent says the KLA is known to have been importing sophisticated anti-tank weaponry in recent months.

The KLA was never a signatory to the deal agreed by President Milosevic and never abandoned the armed struggle for an independent Kosovo, where 90% of the people are ethnic Albanian.

The rebel army declared a unilateral ceasefire, but retained the right to retaliate if fired upon.