The offensive sent the latest Middle East crisis - already the worst in months - soaring and threatened to drag the wider region into its fallout.
Clearing his schedule, Israeli Prime Minister Ehud Olmert called an emergency cabinet meeting for 8:00 pm (1700 GMT), while the military called up a rapid-deployment reserve division of 6,000 troops, headed for Israel's northern border.
Israel has flatly refused to negotiate with Hamas, whose armed wing claimed joint responsibility for the capture of 19-year-old Gilad Shalit along with two other Palestinian groups.
Israel killed 18 Palestinians in Gaza on Wednesday including nine members of one family in an air strike that destroyed a residential building where the army said top Hamas commanders were meeting.
The air raid was among a series of attacks that coincided with an Israeli armoured sweep into the central Gaza Strip, as the Jewish State broadened an offensive aimed at freeing a captured soldier and halting cross-border rocket fire.
The army said the strike on the three-storey building near Gaza City wounded Mohammad Deif, overall leader of the governing Hamas movement's armed wing and Israel's most wanted man.
A spokesman for Hamas's Izz el-Deen al-Qassam Brigades, one of three groups whose kidnapping of Corporal Galid Shalit on June 25 led Israel to launch its first ground operations in Gaza since quitting the territory last year, denied Deif was hurt.
The air strike killed a local Hamas leader, Nabil Abu Selmeya, his wife and seven sons and daughters aged 7 to 19, medics said. His eldest son, who was not at home, survived. A later Israeli air strike using two missiles killed at least five other Palestinians, aged 15 to 20, in central Gaza.
Palestinian medics said Israel's air raids and tank shelling had killed a total of 23 people on Wednesday, including militants and one policeman. Israel has rejected calls from Hamas for negotiations on a prisoner swap for Shalit, whose abduction has triggered the worst fighting between Israelis and Palestinians since 2004.
Israel's army said Deif and other armed wing commanders were meeting in the Gaza building. They were targeted because intelligence showed they were planning attacks, it said. The Israeli army sent dozens of armoured vehicles into central Gaza before dawn, effectively cutting the territory in two. The offensive has piled pressure on the Hamas government, already reeling from a Western aid embargo.
On Israel's northern border, Hizbollah captured two Israeli soldiers and killed up to seven Israeli soldiers in violence further inflaming Middle East tensions.
Hizbollah leader Sayyed Hassan Nasrallah said the capture of two Israeli soldiers was aimed at forcing the release of prisoners in Israel.
"What we did today ... is the only feasible path to free detainees from Israeli jails," Nasrallah told a news conference in Beirut, saying Israeli attacks would not lead to the release of the captured soldiers. He said an Israeli incursion into south Lebanon had been repelled by Hizbollah guerrillas.
Nasrallah said Wednesday's attack was not linked to an Israeli campaign against the Gaza Strip, launched after Palestinian fighters captured an Israeli soldier. He said Hizbollah's decision to capture Israelis was made a long time ago. "Any military operation will not lead to returning the (Israeli) captives. The only means is indirect negotiation and thus a swap," Nasrallah said.
Ehud Olmert blamed Lebanon for the capture of two Israeli soldiers by Hezbollah, branding the attack an act of war by a sovereign state and warning of a "painful price".
He ruled out any negotiations with Hezbollah, backed by Syria and Iran, in a bid to free the servicemen, snatched on Israel's northern border with Lebanon. "This morning's events are not a terror attack but the action of a sovereign state which attacked Israel without any reason," Olmert said.
"Israel will react in a decisive way so that those responsible for the attack will pay a high and painful price," vowed the premier, who is facing his second crisis over captive servicemen in barely a fortnight.
"The Lebanese government is responsible. Lebanon will pay the price," Olmert told a joint news conference with visiting Japanese Prime Minister Junichiro Koizumi. Olmert also vowed no negotiations to release the servicemen.