The strike was part of a larger operation aimed at wiping out the rocket-launching capabilities of militants taking aim at Israeli border towns, the Associated Press reported. Some 300 rockets have been fired at Israel this year, the military said.
Using air strikes, tanks and infantry soldiers, the army focused on the northern Gaza town of Beit Hanoun.
One Israeli soldier was killed in the fighting along with one Palestinian civilian, Reuters reported. Hospital officials said about 45 Palestinians including an 11-year-old boy also were wounded.
Palestinian President Mahmoud Abbas condemned the attack and called for international intervention.
Ghazi Hamad, a spokesman for the Hamas-led government, said Israel was giving itself "a green light in order to continue aggression against our people."
Palestinian militants vowed revenge for the killing of their gunmen and fired six rockets into the Israeli town of Sderot, according to Reuters. No casualties were reported.
"Bombardment for bombardment," Hamas said in a statement. "Blood for blood."
Following a massive withdrawal of settlers from Gaza in September 2005 after a nearly 38-year occupation, Israel returned to the area in June to recover an Israeli soldier captured by Palestinian militants. Though the reconnaissance mission was unsuccessful -- the solider remains in captivity -- the military stayed in the area and widened its mandate in an effort to crush cross-border attacks.
An estimated 280 Palestinians have been killed since, Reuters reported, but Israeli officials claim the offensive is necessary.
"The only thing the Palestinians have exported from the Gaza Strip since September 2005 when Israel left completely have been Qassam rockets," government spokesman Miri Eisin said.
Despite Wednesday's clash, Israeli Prime Minister Ehud Olmert and his Cabinet decided against a wider offensive in Gaza, the AP reported. The Cabinet had planned to expand the assault, reports said Monday.
Violence between Israel and Hamas-led militants has escalated since Hamas took control of the government in January elections. The latest clashes have halted efforts for peace talks between Israel and Abbas, who differs with Hamas Prime Minister Ismail Haniyeh on several key issues.