A sea battle between Tamil Tigers and Sri Lankan government forces has left at least 45 people dead, the navy says.
Sea Tigers should stay away from the sea, say peace monitors
At least 15 sailors are missing after rebels sank a gunboat off the north coast, while at least 30 Tigers were killed in the attack, a spokesman said.
The rebels said only four Sea Tigers were killed when the navy attacked them during a training exercise.
But European peace monitors blamed the rebels for a "gross violation" of the 2002 ceasefire.
About 200 people have died in soaring violence in the past month alone.
"About 15 LTTE [Liberation Tigers of Tamil Eelam] boats including suicide boats attacked one of our vessels transporting 710 soldiers" between Trincomalee and Jaffna, said navy spokesman DKP Dassanayake.
"Navy fast-attack boats escorting the vessel engaged the Tiger boats and one of them was destroyed by a suicide boat," he said.
"There were 15 to 20 sailors in the boat."
The spokesman said that at least five rebel boats were destroyed in the retaliation.
A monitor on board the transport vessel was unharmed.
Spokeswoman Helen Olafsdottir of the Sri Lanka Monitoring Mission told the BBC this was a serious escalation of violence.
"It's getting worse and today it feels more like monitoring war, to be frank," Ms Olafsdottir told the BBC.
She blamed the Tigers for provoking the navy.
"It's very clear that the Sea Tigers have no rights at sea - we have ruled it here in this mission that this is a government-controlled area, because non-state actors cannot control sea and open waters so this is a very, very serious ceasefire violation."
The Sri Lankan retaliation also included air raids south of Kilinochchi - the Tigers' headquarters.
"The air force has bombed our territory, but nothing has fallen here," a Tamil Tiger spokesman said.
Local journalists said Sri Lankan armed forces had also fired artillery shells and some rockets from the direction of the Trincomalee harbour towards Tamil Tiger-controlled areas in the north-eastern province.
The streets of Trincomalee town were almost deserted with most civilians staying inside their homes observing a call for a strike.
Sopan Sivananda, a 22-year-old medical student, was at home in Trincomalee when he heard shelling from the navy point a short distance away.
He said the shelling and firing lasted about one hour.
"We were very frightened. We started collecting our clothes and went downstairs. We thought it was possible that a misfired shell might strike us," he told the BBC.
"This kind of shelling has become more common recently and with it the fear has been getting stronger too," he said.
More than 60,000 people have been killed in Sri Lanka since the LTTE launched its campaign for a separate state in the north and east of the country in 1983.