Meanwhile, Israel officials rejected a key point of a plan aimed at stopping seven months of violence.
The explosion went off near the Jaffa Gate of Jerusalem's walled Old City, police spokesman Shmuel Ben-Ruby said.
The blast occurred along a palm-lined walkway leading to the gate, police said.
Police reinforcements had been sent to Jerusalem on Friday to try to prevent Palestinian rioting after Muslim services, police said.
Earlier, near a main intersection in central Gaza, Palestinians in a car threw hand grenades at an Israeli army position near the Kissufim crossing point between Gaza and Israel, seriously wounding a solider, the military said
In a telephone call to The Associated Press, the Democratic Front for the Liberation of Palestine, a radical group, claimed responsibility for the grenade attack in Gaza, saying it was retaliation for the killing of a 4-month-old baby Monday by Israeli tank fire.
Israel responded by sending tanks and a bulldozer 700 yards into Palestinian-controlled territory, their deepest penetration yet. The United States and others have criticized such incursions in the past.
A police post and five houses were destroyed. Palestinians going through the rubble of their homes fled when Israeli soldiers fired in their direction, witnesses said. Palestinian cars were lined up behind a roadblock after Israeli soldiers cut off the main road through Gaza.
Amid the violence, Israel rejected a call to stop settlement construction, which some feel is a cause of the bloodshed.
A commission headed by ex-U.S. Sen. George Mitchell called for an end to violence by both sides an a halt to Israeli settlement building in the West Bank and Gaza Strip.
The U.S. State Department welcomed the report. Palestinian Planning Minister Nabil Shaath said the Palestinians accept the Mitchell plan and hope Israel would do the same, to "put an end to this nightmare."
Cabinet minister Danny Naveh, who often speaks for the government, said Friday that halting construction meant to accommodate natural growth in the settlements "is something that from the practical point of view, not to mention the principle, is impossible."
Naveh said Israel has decided not to build new settlements. The settlements are not the root of the problem; rather, Palestinian president Yasser Arafat's "strategic decision of terrorism," he told Israel radio.
Palestinians say that Jewish settlements in the West Bank and Gaza are illegal confiscation of their land. They want to set up a state in the West Bank and Gaza and demand that he settlements be removed.
Defense Minister Binyamin Ben-Eliezer told the Maariv daily that he does not believe Arafat can reach a peace agreement with Israel. He said peace would have to await the "next generation" of Palestinian leaders.
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