Five members of the Army of Islam militant group died in an Israeli air strike on their car in Gaza City. In a separate incident, Palestinian witnesses said Israeli shelling killed a gunman and two bystanders in the northern town of Beit Hanoun.
The fighting -- among the bloodiest since Hamas Islamists seized control of Gaza in June -- came hours after militants said they launched more than 12 rockets at the southern Israeli town of Sderot.
Israel sent troops backed by dozens of tanks and armoured bulldozers into Beit Hanoun, a favoured rocket-launching ground, sparking clashes with Hamas and other local gunmen. Palestinian medics said 16 people were injured in Beit Hanoun and five were hurt in the Gaza City strike, all civilians.
Israeli Defence Minister Ehud Barak said there could soon be a broader sweep in Gaza.
''We are getting closer to carrying out a widespread operation in Gaza which, for many reasons, has not taken place in the past weeks,'' Barak told Israel's Army Radio.
Israeli Prime Minister Ehud Olmert has come under pressure from Sderot residents and right-wing politicians to order a large-scale ground operation in the Gaza Strip.
Several Israeli cabinet ministers have cautioned that such a campaign could lead to heavy casualties among Israeli forces and Palestinians in the coastal territory of 1.5 million people.
Hamas leader Ismail Haniyeh denounced on Wednesday ''a new wave of Israeli aggression''. Government spokesman David Baker said Israel would continue to take ''pre-emptive measures'' to prevent rocket attacks or other assaults on its citizens.
PEACE CONFERENCE LOOMS An Israeli military push into the Gaza Strip in the coming weeks could complicate plans for a US-sponsored Middle East peace conference expected in November in the Washington area.
''It must be clear that an operation of this type is not simple, not in terms of the forces and the amount of time which we will have to stay there or in terms of the operational challenges which the troops will have to meet,'' Barak said.
In Beit Hanoun, witnesses said Israeli shells struck a house killing a Popular Resistance Committees (PRC) gunman and two civilian bystanders. Palestinian medics earlier said three were killed but revised down the death toll.
A Israeli army spokeswoman said soldiers fired at a group of Palestinians in Beit Hanoun who were armed with anti-tank missiles and planning to attack the troops.
Asked about the air strike in Gaza City, the military spokeswoman said it targeted an Army of Islam cell that was transporting rockets to launch areas.
Palestinian security sources confirmed the dead were from Army of Islam, a shadowy faction which, along with Hamas and the PRC, abducted an Israeli soldier in a June 2005 border raid.
Last week, Israel declared Gaza an ''enemy entity'' in response to frequent rocket fire -- which rarely causes deaths but has a powerful impact on life along the border -- and said it would reduce fuel and power supplies to the territory.
It has yet to take such actions, which UN officials and human rights groups have said would violate international law pertaining to occupied territories.
Israel pulled out of the Gaza Strip in 2005 after 38 years of occupation. Palestinians say the territory is still effectively under occupation because Israel controls its borders, waters and air space. Israel disputes this.
Reuters KK VP0120