An Apache helicopter fired two missiles at the car near the Palestinian town of Tubas, about 20km (13 miles) from the northern town of Jenin.
The Palestinians say the children were bystanders. The people inside the vehicle - including a member of the al-Aqsa Martyrs Brigades, an armed offshoot of Yasser Arafat's Fatah party - were burnt beyond recognition.
The deaths came as Israeli soldiers arrested Hasan Yousef, the West Bank political leader of the Islamic militant group Hamas.
Army coup
The Israeli army defended the helicopter attack, saying it was part of its ongoing fight against terror networks.
It apologised for the civilian deaths, but claimed that the militant in the car was planning a major attack.
In what is being hailed as a major success for the army, Hasan Yousef was blindfolded and then led from a house in Ramallah which he had been using as a hideout.
Correspondents said Israel had long wanted to catch Mr Yousef, who spearheaded relations with other organisations for Hamas since the start of uprising.
The militant group has claimed responsibility for many suicide bombings which have left hundreds of Israelis dead.
Earlier in the day, two of Mr Yousef's bodyguards were arrested.
Mohammed and Yacub Ashkar were detained in the nearby village of Ein Arik earlier in the day.
'Collaborator' killed
Elsewhere in the West Bank, a Palestinian gunman wounded two people inside a Jewish settlement near Nablus before he was shot dead by Israeli troops.
Palestinian militants also killed a man they accused of collaborating with the Israeli security forces - the third such killing in a week.
Witnesses in a village south of Jenin said masked gunmen took the man to the centre of the village shot him in the head.
Last week the al-Aqsa Martyrs Brigades killed a woman for allegedly collaborating with Israel - the first killing of its kind involving a woman since the Palestinian uprising began two years ago.
Dozens of people accused of having guided Israeli troops to wanted militants have been killed.
Targeted
Correspondents say that Mr Yousef had been on the Israelis' wanted list for months.
A Hamas leader in Gaza, Abdel Aziz Rantisi, told the Associated Press news agency that the uprising would continue.
"Israel is playing with fire and the continuation of arrests, assassinations and aggression against our people and against our leaders will not stop the resistance," he said on hearing of the arrest.
"We warn the occupation against any attempt on the life of Sheikh Yousef and all the others arrested."
Earlier this week, Hamas warned it would again target Israeli civilians to avenge the deaths of four Palestinians - including a 50-year-old mother and her sons - killed during an army raid in Gaza.
Palestinian leader Yasser Arafat accused the Israelis of trying to derail efforts to move towards peace.
After the raid, the Palestinian side also cancelled the latest round of talks with the Israelis which were aimed at implementing an Israeli withdrawal from areas of the West Bank, including Bethlehem, and Gaza.