The Al Aqsa Martyrs Brigades, linked to Palestinian leader Yasser Arafat's Fatah faction, issued a letter left behind by the bomber saying he belonged to the group and was avenging an Israeli raid in Gaza Wednesday that killed eight Palestinians.
Israeli police said the bomb was packed with nuts and bolts to maximize casualties. The blast injured dozens and scattered body parts up to 50 feet from the blast.
"There were a lot of heavy injuries, a lot of the people who were injured were in bad condition, a lot of people had missing limbs," Eli Beer, a paramedic, told the Associated Press.
Jerusalem Post editor in chief Bret Stephens was near the scene at the time of the blast. "There was glass everywhere, human remains everywhere," he told the AP.
The Jerusalem bombing came during a visit by U.S. envoy John Wolf, who met this week with Israel and Palestinian officials to try to revive the stalled peace "road map."
Palestinian Prime Minister Ahmed Qurei condemned the bombing -- the deadliest attack in four months -- and called for peace talks to resume.
David Baker, an official in Israeli Prime Minister Ariel Sharon's office, said the attack shows why Israel needs to build a barrier in the West Bank, a project that Palestinians oppose.
"As long as Palestinian terror continues to target Israeli civilians in the heart of our cities ... then Israel's security fence continues to be essential," Baker told Reuters.
Hours after the blast, Israel released more than 420 prisoners in a long-awaited exchange with Hezbollah in return for an Israeli businessman and the bodies of three Israeli soldiers.
The swap started with the release of 400 Palestinians at Israeli checkpoints in the West Bank and Gaza Strip.
In the second stage, conducted in Germany, another 28 Arab prisoners departed for Lebanon. Minutes later, an Israeli jet took off bringing home businessman Elhanan Tannenbaum and the soldiers' remains. Israel also returned the bodies of 60 Lebanese militants as part of the deal.
Israeli reports had said Tannenbaum's health was failing and that he was tortured by Hezbollah. However, the Associated Press reported he seemed surprisingly fit and walked without assistance.
Asked about his treatment, Tannenbaum told the AP, "I was treated very well by the Hezbollah."
There was mixed reaction to the prisoner exchange.
"Most of those freed were due to be freed in a few months' time anyway," released prisoner Annam Sayel told Reuters. He was sentenced in August 2002 to 28 months in jail for throwing Molotov cocktails and stones at soldiers.
"We are releasing another 400 Palestinians with a very heavy heart, because we know that these 400 will return very quickly to the cycle of violence," Israeli Foreign Ministry spokesman Jonathan Peled said.
With the swap now completed, the sides are set to launch a second stage of negotiations. Those talks are said to concern Ron Arad, who was shot down over Lebanon in 1986 and captured alive. In exchange, Israel would release Lebanese militant Samir Kantar, who has been in an Israeli prison since 1979 for killing three Israelis.