Bulldozers are now a core element of Israel's arsenal
Palestinian medical sources said one Palestinian was killed and at least 13 wounded during the incursion into the Khan Younis camp, where some 80,000 refugees live.
According to an Israeli army spokesman, the operation was in response to mortar attacks on Wednesday evening on the nearby Jewish settlement of Gush Katif.
The tanks have now pulled back from the camp, but some are still positioned on Palestinian territory close by.
A Palestinian security spokesman, Major-General Abdel Razek Majaidie, said Israeli tanks, armoured personnel carriers and a bulldozer had advanced about 800 metres into Palestinian-controlled territory.
Eyewitnesses said at least two houses were demolished by the bulldozer and other homes were badly damaged by tank or machine-gun fire.
'Mortar positions'
Camp leaders used mosque loudspeakers to summon residents to repel the Israeli troops.
The area is one of the front lines in constant violence between Israeli soldiers and Palestinian militants.
The Israeli army, which suffered no casualties during the operation, said that Palestinian militants had fired two more mortars during the operation, and that the houses demolished had been used regularly as mortar positions.
"The goal was to push back the threat, and during the operation the army used explosives to destroy buildings that had long been used as Palestinian firing positions and as dumps for mortar bombs," a spokesman said.
In the West Bank, Israeli troops backed by tanks also raided a Bethlehem township overnight, arresting eight suspected Palestinian militants.
Palestinian radio said one adult and a baby were wounded during the incursion into Al-Shawawirah.
The radio added that Israeli forces had also advanced deeper into the West Bank town of Tulkarem at dawn on Thursday.
Violent protest
On Wednesday, about 3,000 Palestinians attacked a Palestinian police station in the West Bank town of Jenin in protest at the arrest of a local militant leader.
It was not clear whether 20-year-old detainee Mahmud Tawalbeh, who heads the Jenin branch of the Al-Qods (Jerusalem) Brigades, was in the building, but demonstrators tried to get inside.
Police responded with gunfire as demonstrators pelted the station with stones and set fire to parts of it.
Three grenades are also reported to have hit the station, but there were no injuries during the disturbances.
A Palestinian source told a BBC correspondent that Mr Tawalbeh is the most wanted man in the West Bank, being responsible for training Islamic Jihad suicide bombers.
Our correspondent says there are strong feelings among Palestinians that their authorities should not be arresting militants at a time when towns like Jenin are still occupied by Israeli forces.
Israel occupied six Palestinian-governed towns in October after the assassination of cabinet minister Rehavam Zeevi.
It has since left four areas where it has reached an agreement with local security leaders to maintain calm, but the Israeli military remains in force around the towns of Jenin and Tulkarem.
The Israeli government has made it clear it will only withdraw from these areas if the Palestinians can guarantee security and arrest militants.
This puts Palestinian leader Yasser Arafat in a difficult position, says the BBC's Jerusalem correspondent, Caroline Hawley:
"Yasser Arafat again is caught uncomfortably between the competing demands of Israel and the international community on the one hand, and his own people on the other."