Israeli tanks and helicopter gunships were firing at militant positions inside the town.
The gunmen responded with automatic weapons fire and ambulances were racing to the scene.
Security sources say Israeli tanks and bulldozers have also moved a short distance further into the southern Gaza Strip, heading towards the Palestinian town of Abassan.
The sources said that around 50 tanks and bulldozers had moved up to a kilometre further into the south.
An Israeli army spokesman said troops were operating east of Khan Yunis to uncover tunnels, explosive devices or "anything else that can be a threat to forces operating in Israel or elsewhere in the Gaza Strip."
'Buffer zone' set-up
Earlier, Israel began to move deeper into the Gaza Strip to set up a buffer zone against militants who have carried out two rocket attacks that hit targets in the southern Israeli city of Ashkelon.
As tanks moved forward warplanes carried out an air strike near the Jabalya refugee camp in the northern Gaza Strip targetting Palestinians transporting explosives in the area.
Up to 15 Israeli tanks pushed into an industrial zone in the north of the strip, advancing several hundred metres and entered the two former Israeli settlements of Elei Sinai and Nissanit near the Erez border crossing point.
Two Palestinians, a policemen and a Hamas militant were killed seven officers from the Palestinian coastal police were wounded, four seriously during shelling in northern Gaza.
Hospital officials identified the dead militant as Hussam Hijazi, 24.
Palestinians said Hamas militants were operating in the area at the time.
Earlier, another rocket crashed into an open area of Ashkelon without causing damage or casualties, the second Palestinian rocket attack on the Israeli town in two days.
Rice: return soldier
US Secretary of State Condoleezza Rice said in Washington that it was "high time" for Hamas to return an Israeli soldier whose capture sparked the Israeli offensive in the Gaza Strip.
Ms Rice also called on both the Israelis and the Palestinians to exercise restraint.
Prime Minister Ehud Olmert's security cabinet has ordered the military to intensify air raids against Hamas as well as so-called targeted killing operations against militants who launch or order rocket attacks.
The army was also given the go-ahead to surround two key towns in northern Gaza and enlarge a buffer zone using aircraft and artillery, in a bid to stave off rocket attacks.
The current crisis began 10 days ago when a soldier, Gilad Shalit, was captured by Palestinian militants during an attack on an Israeli checkpoint.
Hamas militants fired a new type of rocket with twin engines yesterday into the heart of Ashkelon, the first to hit the centre of the southern coastal town.
It ploughed into a school, causing no injuries but led to furious calls for retribution from members of the Israeli government.
As a result, cabinet instructed Israel’s defence forces to prepare "for prolonged and graduated security activity".
The goals of the campaign were described as "damaging Hamas in the West Bank and Gaza, with an emphasis on institutions and terror infrastructure," and "reducing terrorists' freedom of movement by continuing to section off the Gaza Strip and striking at infrastructures that serve terrorism".
EU caution
Palestinian chief negotiator Saeb Erakat said Israel's plans to enlarge a buffer zone in northern Gaza would only make matters worse.
"Israel is using the recent developments as a pretext to impose faits
accomplis. A security zone will not solve the problem, but on the contrary, help further the escalation and complications," Mr Erekat said.
The EU cautioned that the army's operations had delayed efforts to get much-needed funding to the Palestinian people, as 1.4 million people living in impoverished Gaza Strip grapple with food, fuel and power cuts.
Last night Israeli warplanes attacked the Hamas-run interior ministry in Gaza City for the second time in a week, causing heavy damage and wounding four Palestinians.
Israeli aircraft also pounded other targets in Gaza for the eighth consecutive night.
In the occupied West Bank, Israeli troops shot dead a Palestinian militant of the Al-Aqsa Martyrs Brigades, a rival faction to the Qassam Brigades, and who was wanted for killing two Israelis in 2000.
Meanwhile a car carrying journalists from the Al Jazeera Arabic satellite television channel has been hit by a shell fired from an Israeli tank in
Gaza.
Witnesses said there were some injuries and ambulances are on their way to the northern town of Beit Lahiya.