Moderate Palestinian President Mahmud Abbas and Prime Minister Ismail Haniya, who heads an Islamist-led government boycotted by the West, displayed a rare show of agreement to condemn what they branded an Israeli "massacre".

Medics said at least seven Palestinians, five of them militants, were killed and 40 wounded in the town that witnesses said was surrounded by some 60 Israeli tanks and armoured vehicles.

The ruling Hamas group said four of the dead were members of its military wing while Islamic Jihad said one of its fighters was also killed.

Israeli forces were also partially reoccupying the nearby refugee camp of Jabaliya and the northern town of Beit Lahiya.

Soldiers, hunkered down on rooftops, exchanged fire with militants in Beit Hanun as helicopters and drones flew overhead. Israeli bulldozers razed three houses in the town and another dozen homes were hit by tank shells.

The army said a soldier was killed by Palestinian fire in Beit Hanun, after the armed wings of Hamas and Islamic Jihad said they had killed an enemy serviceman in the besieged town.

Militants also fired two rockets into Israel, one exploding near a public library in the southern town of Sderot, lightly wounding one man and causing a small fire. The other struck in the town's industrial zone, the army said.

Meeting against the backdrop of violence to review operations underway in Gaza for the past four months, Israel's security cabinet ruled out any immediate larger-scale ground offensive.

"The meeting ended without a decision being taken on expanding operations underway, in keeping with the recommendations of Defence Minister Amir Peretz," an official told AFP on condition of anonymity.

Two days ago, Prime Minister Ehud Olmert had warned Israel could expand its offensive in Gaza, as his chief ally, the United States, described Israeli military operations in the Palestinian territory as an issue of "self-defence."

On Wednesday, his office said only that "current security operations" would continue to increase pressure on Hamas and "other terrorist operations" to stop them from regrouping and to end rocket attacks.

An army spokesman confirmed that a "major operation" was underway, codenamed "Operation Autumn Clouds", in which three air raids had been carried out and "30 armed Palestinians were hit".

"Our goal is to significantly decrease the Qassam launching capability," Peretz was quoted as saying while touring Israeli units deployed near Gaza, even as more of the improvised rockets hit Israel.

"This military operation targets terrorist elements. Army activities will continue until soldier Gilad Shalit is released," said one military broadcast on pirated radio frequencies in Arabic in Gaza.

Shalit was captured in a June 25 raid by Gaza militants, including some from Hamas, that has sparked four months of Israeli operations that have killed some 270 Palestinians and three Israeli soldiers.

Troops were also operating around the closed international airport in southern Gaza and the nearby village of Shoka, security sources said.

The Palestinian president and prime minister swiftly slammed the latest offensive in the battle-scared and impoverished territory.

"President Mahmud Abbas has strongly condemned the Israeli massacre that has left six martyrs and nearly 40 wounded in Beit Hanun," his office said.

Abbas called on the "occupation government to cease immediately all hostile actions against our people" and urged the international community to "intervene rapidly" to end the aggressions and stave off a "new deterioration".

At the opening of an emergency cabinet meeting, Haniya charged: "The massacre is the first consequence of Lieberman joining the Israeli government."

Hard-right politician Avigdor Lieberman, who became Israel's first strategic affairs minister on Monday, reportedly suggested to the cabinet in Jerusalem that Israel apply tactics used by the Russian army in Chechnya, to Gaza.

Israel has repeatedly said it has no intention of reoccupying Gaza, from which it withdrew troops and settlers last year after a 38-year presence.