A heavy gun battle erupted in the West Bank town of Ramallah late Tuesday, and witnesses said Israeli troops at one point fired tank shells to disperse Palestinian gunmen.
A building occupied Israeli Defence Forces (IDF) came under fire from Palestinian snipers shooting from the City Inn neighbourhood of Ramallah.
IDF forces countered with heavy gunfire and tank shells.
Meanwhile, thousands of Palestinians marched in the funeral procession of the three Palestinians, two of them children, who were killed on Monday night, when an explosion in Ramallah flattened a two-storey building almost directly opposite Palestinian President Yasser Arafat's headquarters.
The funeral of the victims, a four-year-old girl, a boy of seven and a 24 year-old Palestinian gunman of Arafat's Fatah
group, drew thousands to the streets of Ramallah.
Palestinian sources disagreed over whether Israelis or Palestinians had caused the blast.
A Palestinian policeman was killed and a woman civilian critically wounded in a firefight between Israeli troops and Palestinian gunmen near the Rafah refugee camp in the Gaza Strip.
In Ofra, on the West Bank, a settler killed in his car on the outskirts of Ramallah was buried.
The slain Israeli motorist was identified as Assaf Hershkovitz, 31, a resident of the Jewish settlement of Ofra whose father Arieh was killed in another West Bank drive-by shooting in January.
The Islamic militant group Hamas claimed responsibility for the shooting, saying it was meant to avenge the Palestinians killed in separate blasts Monday.
The renewed violence and mourning came as Israeli Foreign Minister Shimon Peres was discussing a new joint Egyptian/Jordanian peace initiave in the United States.
Israeli Prime Minister Ariel Sharon says Yasser Arafat is responsible for the escalation in violence, claiming the Palestinian leader has "complete control over events" and is running terror groups.
But as Israel's Defence Minister Binyamin Ben Eliezer toured an airforce base at Tel Nof, he came under heavy criticism from Palestinian ministers for - what they claim - are his war-mongering ways.
Palestinian Information Minister, Yasser Abed Rabbo accused Ben Eliezer of being a fanatic who only understood the language of war and rejected Palestinian peace overtures like those suggested in the Jordanian/Egyptian initiative.
In the Gaza Strip, a Palestinian policeman was killed and a woman civilian critically wounded in a firefight between Israeli troops and Palestinian gunmen near the Rafah refugee camp.
Elsewhere in Gaza, Palestinians fired two mortar shells at a Jewish settlement, causing no injuries.