The dispute threatens a deal to end the siege
The new setback came as the Israeli army prepared Manger Square for the evacuation of most of the beseiged Palestinians. An earlier snag delaying an end to the stand-off had already been resolved.
Israel army radio said the army began calling up emergency reservists on Thursday after the cabinet said Israel would retaliate for the attack.
Israeli military sources say that, according to intelligence reports from Gaza, more Palestinian suicide attacks are planned.
Setback
Last-minute talks to finalise an end to the siege broke down after Palestinians due to temporarily remain in the church demanded a European official be brought in to protect them as others inside are evacuated.
Under an agreement already worked out, 26 militants inside the church would be transferred to jail in Gaza, while about 80 Palestinians and international activists would be allowed to go free.
Thirteen Palestinians, whom Israel descibes as "senior terrorists," would stay in the church until they could be exiled to a foreign country.
Negotiations to resolve the latest impasse resumed on Thursday afternoon.
The Palestinians sought refuge in the church after Israeli troops stormed into Bethlehem on 2 April to root out militants from the city.
Militants arrested
In Gaza, Hamas officials said Palestinian police had arrested at least 14 militants on Thursday morning.
The detentions came after Yasser Arafat ordered his security forces "to confront and prevent all terrorist operations against Israeli civilians" after the attack on a social club in Rishon Letzion.
The bombing is believed to have been carried out by a Hamas member from Gaza.
However, correspondents note that in the past the Palestinian authorities have temporarily detained Hamas activists, but released them soon after.
Gaza fears
The BBC's Kylie Morris in Gaza says there is growing unease among Palestinians who fear an imminent Israeli strike there.
Israeli Transport Minister Ephraim Sneh told Israel radio the cabinet agreed "on the necessity of our troops intervening against the terrorist infrastructures in the Gaza Strip".
An Israeli Government statement said the cabinet on Wednesday night approved retaliation for the suicide attack, but it did not elaborate.
The West Bank has been the focus of recent Israeli military operations to root out Palestinian militants and the army has not so far entered Gaza on a large scale.
Israeli media said the suicide bomber came from Gaza, where Hamas' headquarters and senior leaders are based.