More than 800 people have died this year and ambushes, air strikes and naval clashes had become commonplace, but it was a dispute over a rebel-held water supply that led to the first major ground fighting since a 2002 ceasefire.

"Right now, it's very localised," said a diplomatic source. "But I think it will spread because the Tigers need to make the government wonder where to put their troops next."

The military said small units of troops were fanning out through the eastern town of Mutur to drive out rebels who pushed into the town on Wednesday and are holed up in homes and buildings.

"There are firefights and mortar and artillery fire still going on," said a military spokesman. "Some Tigers are still in the town and are firing at our troops with small arms. They are surrounded and trying to move east back to their own territory."

As jets roared overhead, people stayed on the streets of Trincomalee town around 6 miles (10km) across the harbour of the same name, but most shops stayed shut in sympathy with residents of mainly Muslim Mutur. "This is a Muslim neighbourhood, but our shop is shut too," said Hindu general store owner R. Sigamany. "We are closed down in solidarity because people from all communities are dying."

Isolated violence also flashed in Mannar over on the northwest coast, where the military said Tigers ambushed an patrol with a Claymore fragmentation mine and 81 mm mortar bombs. Two soldiers were injured.

Both sides say they want peace but diplomats fear the truce may become irrelevant and a two-decade civil war that has killed more than 65,000 people will resume.