Six Israeli soldiers have been killed when their armoured personnel carrier was blown up during a Gaza City raid.
Analysts say the incident is a serious blow to Israeli forces
The Palestinian militant group Hamas says it placed the bomb that destroyed the vehicle during clashes that also left seven Palestinians dead.
The Israeli toll is said to be the highest for the army in a single operation in nearly two years.
Israeli Prime Minister Ariel Sharon vowed that Israel would seek out and hit militants "wherever they hide".
He has called an emergency meeting of his inner Cabinet to discuss how to respond to the deaths.
On Tuesday afternoon, an Israeli helicopter gunship fired a missile at a Palestinian car in Gaza City. Palestinian sources say two militants were injured and a 14-year-old boy was killed.
Gunbattles left six Palestinians dead including two members of the Hamas movement.
Militants display 'trophies'
The explosion that killed the soldiers came after several hours of street fighting on the southern side of Gaza City.
The Israelis had gone into the Zeitoun area looking for workshops where militants manufacture the rockets that they fire at Israeli settlements.
But militants poured into the southern district to confront the troops, leading to what the BBC's Alan Johnston in Gaza calls the fiercest fighting seen in Gaza for months.
Hamas said it had drawn the vehicle into an area where it had several bombs waiting, and filmed the explosion.
The deaths of the Israeli soldiers were announced from loudspeakers in mosques.
Hooded militants have toured the city showing off what they say are pieces of wrecked Israeli equipment.
'Blow to Israel'
The Israelis said they had found more than 30 machines used for making weapons in Zeitoun. The Palestinians say four workshops were hit.
BBC Middle East analyst Roger Hardy says the deaths of the soldiers will be a serious blow to Israeli forces.
Israel responded to the explosion with a missile strike on a car
He says Hamas supporters will see it as proof that the organisation has the ability to strike back to avenge the killing of two of its top leaders by the Israelis in March and April.
In mid-afternoon, Israeli troops were still reported to be bogged down in the narrow streets of Gaza City in an operation to retrieve the bodies of the dead soldiers.
The latest violence comes as Mr Sharon struggles to keep alive his plan for a unilateral Israeli withdrawal from Gaza.
Mr Sharon has vowed to crush Palestinian militants who regularly launch mortar and other attacks out of the Gaza Strip into Israel.
About 130 Palestinian homes have been destroyed this month in what the UN agency for Palestinian refugees says is one of the most intense periods of destruction for years.
The group says Israel is meting out illegal collective punishment after the killing of a settler and her four daughters in Gaza last week.
The Israeli army has described the UN figures as exaggerated. It said the demolitions were only carried out on buildings they knew to have been used by militants to attack Israeli targets.
Israeli forces backed by tanks and bulldozers also entered the Rafah refugee camp in the Gaza Strip early on Tuesday and tore down a structure.
The latest Israeli deaths are the worst single blow to the army since November 2002, when eight Israeli soldiers, along with a border patrol officer and three civilian guards, were killed in an ambush in the West Bank city of Hebron.