Israel has launched missile strikes on Gaza, killing eight Palestinians, hours after Prime Minister Ariel Sharon vowed to retaliate for a suicide bombing.
A crowd gathered around the car destroyed in the attack
A leading member of Islamic Jihad and three other members of the militant group were among those killed.
Israel later fired missiles into an area which the army said was used by militants to launch rockets.
Five Israelis were killed in a suicide bombing in Hadera on Wednesday. Islamic Jihad said it carried out the attack.
Palestinian officials have condemned Israel for the air raid on the Gaza Strip, saying there would be serious repercussions for all sides if such attacks continued.
Israeli Defence Minister Shaul Mofaz has told an Israeli newspaper that he doubts whether Israel can reach a comprehensive peace settlement with the current Palestinian leadership.
In an interview with Yediot Aharonot, Mr Mofaz said it would be necessary to wait for the next generation to emerge.
"We could reach interim agreements [but] I don't think that a Palestinian state will see the light of day in the coming years," Mr Mofaz added.
In Gaza, witnesses said Israeli missiles struck a white Subaru car that was travelling between the northern refugee camp of Jabaliya and the town of Beit Lahiya.
Islamic Jihad's field commander in northern Gaza, Shadi Mohanna, died along with his assistant, Mohammed Ghazaineh.
Four bystanders were killed and 15 others hurt, the BBC's Alan Johnston reports from Gaza.
The attack came just after special prayers for the holy month of Ramadan had ended and the street was crowded with people.
"The explosion was very powerful, and flying metal from the car and the missile wounded many of the people walking in the street," said a witness who gave his name as Nidal.
Israel's military said it had carried out an attack on "a vehicle carrying a senior Islamic Jihad terrorist who was responsible for several murderous terrorist attacks".
Television pictures showed furious scenes as Palestinians gathered at the scene of the evening attacks.
Islamic Jihad said one of its suicide bombers had struck in Hadera to avenge the Israeli army's killing on Monday of Luay Saadi, one of its leading figures in the occupied West Bank - a man whom the Israelis accused of masterminding suicide attacks.
In the aftermath of the Gaza air strike, a local Islamic Jihad leader said his group would hit back.
Palestinian negotiator Saeb Erekat condemned the Israeli attack and warned of "the consequences of this escalation".
Earlier, Israel arrested another leading member of Islamic Jihad, Abdel Khalim Izzedine, in a raid on the West Bank town of Jenin.
It came shortly after Mr Sharon warned that Israel would pursue its policy of targeting Palestinian militants.
On Thursday he vowed "wide-ranging and ceaseless" operations against Palestinian militants in response to the Hadera bombing.
"We were dealt a harsh blow by the terrorists... Our activity will be wide-ranging and ceaseless, until we succeed in putting an end to terrorism," he said.