Israeli tanks and bulldozers have moved deep into the southern Gaza Strip in the biggest incursion into the territory in months.
Israeli tanks severed the main north-south route through Gaza
Three Palestinian militants were killed early in the fighting, local medical officials said.
Israeli military officials say two soldiers were wounded. Reports speak of 30 or more tanks being involved.
Gaza is run by the Hamas militant group which took over the territory in June after a violent struggle with Fatah.
The BBC's Aleem Maqbool in Ramallah says it is the largest military incursion of Gaza for months, coming exactly two weeks after the Annapolis meeting that heralded a new round of peace negotiations.
On Wednesday, Israel and a Fatah-led Palestinian delegation are to hold a first round of talks aimed at relaunching the peace process.
Since that meeting nearly 40 Palestinians, mainly militants, have been killed in Gaza by Israeli forces.
The incursion was launched not far from the Sufa crossing point into Gaza, an area regularly used by militants to launch rocket and mortar attacks at Israel.
The Israeli force cut traffic on the main road between Khan Younis and Rafah, and encountered fierce resistance from Palestinian fighters, witnesses said.
A petrol station was reportedly demolished, and three Islamic Jihad militants were killed when an Israeli missile struck a house.
"During the latest period, with all the mortar shelling and rocket launching coming from the area... it's not something out of the ordinary," an Israeli spokeswoman said.
But correspondents on the scene said it looked anything but routine, with bodies lying amid the rubble of a destroyed building and Israeli tanks pushing deep into Palestinian territory.
Schoolchildren ran through the streets of Khan Younis, the largest town in southern Gaza, after schools closed so they could take refuge at home.
Dozens of people were detained in house-to-house raids by the Israeli troops, residents said.
The Israeli troops were injured when their tank was hit by a grenade. The vehicle was left smouldering, witnesses said.
Hours before the operations an Islamic Jihad militant was killed in an Israeli air strike, local medical officials said.
Israeli government spokesman Mark Regev told the BBC the operation was designed to protect Israel's civilian population.
"We've had over the last few months some 4,000 rockets fired from Gaza into Israeli territory, trying to kill Israeli civilians.
"We do believe that [with] these sort of surgical incursions where we go in, we deal with the infrastructure of the extremists, of the terrorists - we keep them on the run, we keep them playing defence," he said.
Palestinian officials have accused Israel of trying to derail peace talks before they start, with the announcement of tenders to expand a settlement in occupied East Jerusalem.
Israel denies this saying past obligations to cease settlement activity did not apply in that area.
Hamas, which won parliamentary elections January 2006, has been excluded from the Annapolis talks and from the negotiations that are about to be launched. It does not recognise Israel.