Khaled al-Dahduh, also known as Abu al-Walid, died instantly when a vehicle exploded in a ball of flames near the finance ministry in Gaza City, medics and witnesses said.
Witnesses claim Mr Dahduh was killed as a result of an Israeli air strike carried out by an unmanned drone, but the Israeli army insisted it was not behind the blast.
"The IDF (Israel Defence Forces) was not involved," an army spokeswoman told news agency AFP. "The IDF had no connection to the incident."
Mr Dahduh was the overall leader of the Al-Quds Brigades, the armed wing of the ultra-radical Islamic Jihad faction which boycotted the general election won five weeks ago by the larger Islamist group Hamas.
Islamic Jihad official Khaled al-Batsh insisted Mr Dahduh was "assassinated" by Israel while standing in the street when the car, which did not belong to him, was gutted.
Mr Batsh maintained that the car exploded, either when an Israeli drone fired a rocket or a bomb was detonated by remote control.
Abu Ahmed, a commander of the Al-Quds Brigades, threatened to avenge his killing and "strike the heart of the Zionist entity" in retaliation.
A Palestinian interior ministry investigation is underway to determine the precise circumstances of Mr Dahduh's assassination.
News of his death emerged as an Israeli working at a service station near a Jewish settlement in the northern West Bank was fatally wounded in a drive-by Palestinian shooting, claimed by the radical Al-Aqsa Martyrs Brigades.
Another Israeli was seriously wounded in a separate shooting elsewhere in the northern West Bank similarly claimed by Al-Aqsa.
While Hamas has halted its campaign of attacks in the past year, Islamic Jihad has carried out half a dozen suicide bombings inside Israel.
Yet Hamas has so far resisted international pressure to renounce violence, as well as refusing to recognise Israel's right to exist and the agreements previously signed by the Palestinian Authority and the Jewish state.
Israel adamant
In a bid to stiffen the pressure against the group, Israeli Foreign Minister Tzipi Livni embarked on her first trip to Europe where she was due to meet her counterparts from Britain, France and Austria.
In Vienna, she reiterated that Israel would not transfer money owed to the Palestinian Authority despite an EU decision earlier this week to release funds.
Asked about recent remarks in which she called Palestinian Authority president Mahmoud Abbas "irrelevant" she said she respected him, but that Israel considered the era of the caretaker Palestinian government over.
"The sad reality is that the Hamas won the elections and that Mahmoud Abbas is giving it the possibility to form a government without putting real conditions. This is the end of the so-called caretaker government."
The moderate Mr Abbas says he remains committed to negotiating a settlement to the Middle East conflict.
As Israel's election campaign notched up a gear, Israel's opposition Labour party leader, Amir Peretz, announced he would meet Mr Abbas on Thursday.
The talks at the Allenby crossing between Jordan and the West Bank will make Mr Peretz the first senior Israeli politician to meet the Palestinian leader since Hamas won the election.
On Friday, Hamas’ political leader, Khaled Meshaal, begins a landmark visit to Moscow.
Mr Meshaal told Russia's Vremya Novostei daily that EU aid, welcomed by Hamas and the cash-strapped Palestinian Authority, would not persuade Hamas to change its anti-Israeli policy positions.