The leader of Lebanon's militant Hezbollah has said two captured Israeli soldiers will only be returned through talks and a prisoner exchange.
Israel threatened "very painful and far-reaching" action
Hassan Nasrallah said if Israel wanted to escalate the crisis his forces were ready for confrontation.
Israel launched an assault in southern Lebanon using planes, tanks and gunboats following the capture.
Three Israeli troops were killed in Hezbollah's cross-border raid and four more died in the subsequent offensive.
The second incident occurred when a tank involved in the ground operation hit a mine.
If the Israeli enemy wants escalation, we are ready for the confrontation
Roads and Hezbollah outposts were hit and two civilians killed as Israeli forces entered Lebanon, in their first incursion since 2000.
Israeli Prime Minister Ehud Olmert described Lebanon's actions as an "act of war".
He said he held Beirut responsible for the fate of the two soldiers and that it would pay a "heavy price".
However, Lebanese Prime Minister Fuad Siniora said he had not known about the Hezbollah operation and refused to take responsibility for the soldiers' capture.
"The government was not aware of and does not take responsibility for, nor endorses what happened on the international border," Reuters news agency quoted him as saying.
Mr Olmert was due to hold an emergency cabinet meeting to discuss further action, although he has already ruled out negotiations.
Israel has filed a complaint with the United Nations, urging the Security Council to enforce resolutions calling on the Lebanese government to disarm militias and extend its authority throughout its territory.
In Washington, the White House has called for the immediate release of the captured Israeli soldiers, saying it held Iran and Syria responsible for the attack.
The news of the clashes comes amid a major Israeli offensive in the Gaza Strip. Israel has been trying to secure the release of a 19-year-old soldier, Cpl Gilad Shalit, who was captured by Palestinian militants on 25 June.
Hezbollah is seeking the return of Palestinian, Lebanese and other Arab prisoners held in Israeli jails.
Mr Nasrallah said any invasion of Lebanese territory would be met by force.
"The prisoners in our hands will not return to Israel except through indirect negotiations and exchange of prisoners and peace," he said.
"If the Israelis are thinking about carrying out a military operation to recover them they are dreaming."
"We are not seeking escalation, we don't want to lead the region into war. However, if the Israeli enemy wants escalation, we are ready for the confrontation."
He said what Hezbollah had done was the "only feasible path" to freeing detainees in Israeli jails, and "our natural right".
The operation had been planned for several months, he added, long before the capture of Cpl Shalit in Gaza.
UN Secretary General Kofi Annan both condemned Israel's Lebanon offensive and called for the soldiers' release.
Israel ended its occupation of southern Lebanon six years ago.
Army Chief of Staff Lt-Gen Dan Halutz said the Israeli military would "turn back the clock in Lebanon by 20 years" if the soldiers were not returned.
Several thousand reservists will be deployed along the border, officials say.
In other developments:
- On Wednesday morning, Hezbollah launched dozens of Katyusha rockets and mortar bombs at the Israeli town of Shlomi and at Israeli outposts in the Shebaa Farms area
- Later Hezbollah said its fighters had destroyed an Israeli tank attempting to cross the border
- Two civilians were killed when Israeli planes bombed a road bridge on a major route though southern Lebanon.