The United States said it was "deeply trouble" by the raid in which 110 Palestinians were wounded, 25 of them in critical condition, doctors said. Most suffered shrapnel wounds in the head, chest and abdomen. The dead ranged in age from 14 to 52.
Palestinians said the dead were civilians, while Israel said most were fighters killed in battle.
Israeli said its troops were searching for Hamas militants when they raided the town of Khan Younis with 40 tanks backed by helicopters shortly after midnight Monday.
The Islamic militant group Hamas promised revenge.
"Everyone should know that as our people were not safe in Khan Younis, so Israelis will not be safe in Tel Aviv," said Abdel Aziz Rantisi, a Hamas leader. "We will strike everywhere."
In Washington, State Department spokesman Richard Boucher couched U.S. criticism of the operation with a restatement of American support for Israel's right to self-defense.
"We're deeply troubled by the reports of Israeli actions in Gaza over the weekend," he said, while adding: "We've always respected Israel's right to defend itself, including going after armed groups and armed men in some of these areas."
Javier Solana, the European Union's visiting foreign policy chief, said he was shocked by the number of casualties. "I think that it is even more dramatic because of the efforts that the Palestinian people were making in order to get out of the way of violence in recent weeks," he said.
Israel's deputy defense minister, Weizman Shiri, regretted the loss of civilian life. "But what can we do?" he said. "It's war."
Israeli troops also fired machine guns and assault rifles at a Khan Younis hospital where most of the wounded were taken, killing one man and injuring three people. The military said the shots were fired in response to mortar fire, and witnesses said they heard two explosions before the shooting began.
Palestinians denounced the Israeli strike, the deadliest since July, as a massacre and called for international protection. Israeli officials said Palestinians militants were responsible for the casualties because they took cover among civilians.
The military said Khan Younis is a Hamas stronghold and that during the raid troops arrested a wanted man carrying a homemade explosive device. However, there was no indication of a particular target, as in previous strikes against wanted militants that also claimed civilian casualties.
The Israeli military said the missile was aimed at a group of armed men who were attacking soldiers with guns and grenades. The missile was fired toward the end of the raid.
Wissam Abdeen, 29, said that as troops withdrew, residents emerged from their homes to inspect the damage and check on the fate of friends and relatives.
Abdeen said there were no gunmen in the crowd.
However, another witness, Walid Sabah, 44, said gunmen were among those gathering in the street, but did not shoot at the time. Sabah said he was in the crowd with his 17-year-old son, Abdullah, who was killed in the missile strike.
Abdeen said that as troops withdrew, he heard the sound of helicopters. "Two minutes later, I heard the sound of something coming from the air and I saw the flames. Then a big explosion lifted me and blew me 10 yards away," he said. Abdeen was hit by shrapnel in his arm.
Another resident, Abedi Ashour, 24, said he was emerging from his apartment when he heard the explosion. "People were bleeding, many of them lying on the ground. Women were screaming and blood covered the ground," he said.
Brig. Gen. Israel Ziff, the Israeli army commander in the area, said troops met heavy resistance from Palestinian gunmen. He said that as troops withdrew, many armed men gathered in the streets. "They fired a lot and threw grenades. There was a battle there," Ziff said. "The helicopter aimed at this armed group and hit them."
Ziff said the battle was filmed from a pilotless plane.
The army has not yet decided on an Associated Press request to see the footage.
In other developments Monday: