Settlers and the soldiers protecting them came under fire as they walked into the West Bank city of Hebron to worship at the Tomb of the Patriarchs, a shrine revered by both Muslims and Jews.
The militant Palestinian group Islamic Jihad claimed responsibility for the attack, which included sniper fire from a nearby hilltop, Israeli TV reported.
Hebron, which had been relatively free from violence in recent weeks, is home to about 450 Jewish settlers and 130,000 Palestinians.
Thousands of Israelis live in the nearby settlement of Kiryat Arba and many walk to the tomb, which is said to mark the burial place of Abraham, Isaac and Jacob, every Friday evening. One Israeli military official called the attack a well-timed ambush.
Located 25 miles south of Jerusalem, the city has seen a century of violence. Arab riots in 1929 drove out hundreds of Jews who had lived there for centuries, while dozens of others were massacred.
In 1994, Baruch Goldstein, a New York-born settler from Kiryat Arba, opened fire in a mosque at the Tomb of the Patriarchs, killing 29 Muslim worshippers. He was beaten to death by the survivors.
The Hebron settlements are controversial within the Israeli government, with some politicians criticizing the high cost of protecting the settlers and calling for their evacuation.
However, the settlers have maintained their religious right to live near the tomb and other holy sites.