UN Secretary General Kofi Annan, at Middle East crisis talks in Rome, has called for an immediate ceasefire from both Hezbollah and Israel.
Israel had hit Khiam a number of times earlier on Tuesday
He said Israel should halt all ground operations, bombardments and blockades, and Hezbollah stop deliberately targeting Israeli population centres.
Fighting is continuing in south Lebanon though vital aid is now on the way.
His comments come as outcry over the death of four UN observers in Lebanon, killed by an Israeli jet, grows.
According to an initial UN investigation into the incident the observers were subjected to a six-hour bomb attack by Israeli forces during which they called Israel's military 10 times to tell them to stop.
The Rome summit, which was called by US Secretary of State Condoleezza Rice, brings together EU and Arab nations plus the US and Russia, but not Israel, Iran or Syria.
One of the key items on the agenda is the proposal for an international peacekeeping force to police southern Lebanon.
A number of countries which have been named as possible contributors to such a force are attending the summit.
On Tuesday, Israeli Defence Minister Amir Peretz said Israel would establish what he called a security zone in southern Lebanon which would be maintained under the control of Israeli forces if there was no multinational force.
In other developments:
- A Jordanian military plane arrives in Beirut to evacuate some of the most seriously wounded Lebanese civilians
- Ten trucks loaded with food and medical supplies head from Beirut to the beleaguered south of the country
- Hezbollah's leader Hassan Nasrallah warns on TV that his organisation will begin firing rockets further south into Israel than Haifa
BBC diplomatic correspondent Bridget Kendall says the Italian prime minister and others believe a quick ceasefire is the main priority.
A Jordanian plane will evacuate some of the worst injured
But the US and Britain will not push for a truce unless the root causes of the conflict are addressed, our correspondent adds, and officials from both countries have been downplaying expectations of any far-reaching conclusions.
It is the third day of Ms Rice's diplomatic mission to ease the crisis, having travelled to Lebanon, Israel and the West Bank earlier in the week.
On Tuesday evening Ms Rice was meeting Mr Annan in Rome when news of Israel's bombing of a UN observer post in Khiam in southern Lebanon broke.
The observers were part of the Untso mission - the first peacekeeping operation ever established by the UN, which has been operating in the Middle East since 1948, and currently has about 150 observers.
The observers had taken shelter in a bunker under their base because there had already been 14 Israeli artillery attacks on their position.
The BBC's Paul Adams says that they called the Israeli military 10 times over a period of six hours to tell them to stop shelling before they were killed with a precision guided missile.
Four unarmed observers, from Austria, Canada, China and Finland, died in the attack.
A UN rescue team also came under fire as it searched the rubble for survivors.
In a statement on Tuesday Mr Annan was quick to say the attack was the result of "apparently deliberate targeting by Israeli Defence Forces". He demanded a full investigation.
Israeli Prime Minister Ehud Olmert has expressed his regret over the deaths in a phone call to Mr Annan, saying that the post was hit by mistake.
Governments around the world have condemned the attack. Lebanese Foreign Minister Fawzi Sallukh, described it as barbaric and premeditated aggression.
More than 380 Lebanese and 42 Israelis have died in two weeks of conflict, which began after Hezbollah captured two Israeli soldiers in a cross-border raid on 12 July.
The situation is particularly bad in the south where many people found themselves trapped amid the conflict after Israeli war planes bombed bridges and roads that could have offered escape.
Overnight there was more fierce fighting between Israeli ground troops and Hezbollah militants around the Lebanese town of Bint Jbeil and there have been unconfirmed reports in Arab media that at least nine Israeli troops have died.
The roads to the south-east of Tyre are filled with cars carrying refugees from village near the border with Israel where the heaviest fighting has been going on - Yaroun, Maroun al-Ras and Bint Jbail.
Hezbollah attacks on Israel have continued - on Wednesday morning the city of Haifa was once again hit by rockets.