Two Israeli soldiers were killed and seven were wounded in the clashes, the military said.
The violence took a heavy toll on Gaza civilians. Moderate Palestinian leaders called the killings a "genocide" and threatened to call off peace talks.
"The response to these rockets can't be that harsh and heinous," said Palestinian President Mahmoud Abbas. "It is nowadays described as a holocaust."
The spasm of violence came days before Secretary of State Condoleezza Rice was to arrive in the region to nudge Israel and Palestinians closer to a peace accord. But the rising tensions threatened to mar her visit.
Early Sunday, Israeli aircraft destroyed the office building in Gaza City used by Hamas Prime Minister Ismail Haniyeh, witnesses said. Five people were lightly wounded in the raid, seen as a signal that Israel holds the Hamas political leadership responsible for the violence.
While expressing regret for civilian casualties, Israeli Defense Minister Ehud Barak blamed "Hamas and those firing rockets at Israel," his office said in a statement, pledging to continue the offensive to protect Israeli towns and cities.
On Friday, Israeli Deputy Defense Minister Matan Vilnai renewed a threat to invade Gaza to crush militant rocket squads that attack southern Israel daily.
At least two dozen Palestinian civilians, including a baby, were among those killed, and militants said 25 fighters died. Health officials said about 200 people were wounded, 14 of them critically.
The overall death toll was the highest in a single day since the current round of violence erupted in September 2000. The highest previous death toll was 38 on March 8, 2002.
The intense fighting Saturday pushed the Palestinian death toll to more than 80 since fighting flared Wednesday. About half of those were civilians.
Palestinian fighters kept up a steady stream of rocket and mortar attacks on Israeli targets, firing around 50 on Saturday alone in defiance of the Israeli assault. Six Israelis were injured by rockets that reached as far as Ashkelon, a coastal city 11 miles north of Gaza.
The Israeli military said one of its airstrikes on northern Gaza targeted a parked truck loaded with 160 rockets.
On Thursday, militants raised the stakes by firing Iranian-made rockets into Ashkelon, striking closer to Israel's heartland than ever before and putting more Israelis at risk. Palestinian rocket fire earlier in the week also killed an Israeli man.
Shortly before midnight Friday in the northern town of Beit Hanoun, a 13-month-old girl was killed by shrapnel. Hamas blamed Israel, but residents said a militant rocket fell short and landed near the baby's house. The day's violence snowballed from that point on.
Before dawn Saturday, the battleground shifted to the town of Jebaliya and its nearby refugee camp, a center of militant activity in northern Gaza.
Soldiers backed by tanks and aircraft conducted house-to-house searches and took up positions on rooftops as they clashed with militants detonating land mines and firing heavy machine guns, assault rifles and mortar rounds.
A wounded man and boy lay in a gutter near a dead man. Ambulance workers took away the dead man as a youth appealed to paramedics to treat the wounded.
"Take them, they are still alive," he pleaded. Another man urged the wounded to "bear witness," or proclaim their Muslim faith before they die. The two began reciting a Muslim prayer near a boy whose lower body was ripped by shrapnel.
Tareq Dardouna, a Jebaliya resident, said a relative was killed outside his home in the crossfire that began at 3 a.m.
"His body is still on the ground," Dardouna said in a telephone interview from his home, where he was tending to four wounded people amid screaming children. "Ambulances tried to come, but they came under fire. ... We are in a real war."
At one of the damaged houses, paramedics rushed an unmoving woman lying on a stretcher, her face covered with a cloth, out of a room clouded with dust.
By evening, more than 40 Palestinians and two Israeli soldiers had been killed in the Jebaliya fighting.
All but the most critically injured were sent home from Shifa Hospital, Gaza's largest. Beds crammed hospital corridors, and the intensive care unit was overflowing, a doctor at the hospital said. The doctors union urged its members to cancel leaves and appealed for blood donations.
The U.N. shuttered 37 schools it runs in northern Gaza because of the fighting, affecting some 40,000 students said Christopher Gunness, a U.N. official. A three-day strike was declared in Gaza, and publicly run schools and universities were closed.
Mosques across northern Gaza and Hamas-affiliated radio appealed to civilians to stay home. Hamas closed off roads to evacuate security compounds and to keep residents away from potential airstrike targets. They also turned off street lights, apparently so militants wouldn't be seen from the air.
Chief Palestinian negotiator Ahmed Qureia said Palestinian leaders including Abbas recommended suspending peace talks at a meeting Saturday in the West Bank town of Ramallah.
"I think it will be suspended," Qureia said. "What is happening in Gaza is a massacre of civilians, women and children, a collective killing, genocide," Qureia added. "We can't bear what the Israelis are doing, and what the Israelis are doing doesn't led the peace process any credibility."
Hamas remained defiant and vowed to retaliate.
Hamas Leader Lashes Out At Israel, Likens Gaza Fighting To Holocaust
In Syria, exiled Hamas leader Khaled Mashaal described Israeli attacks against civilians in Gaza as "the real Holocaust."
"If (Israeli officials) decided stupidly to invade Gaza, we will fight them with God's help," Mashaal told reporters from his base in Damascus. "We will fight them like lions."
Mashaal blamed the rival Fatah, headed by Abbas, for helping along Israel's attacks.
"I accuse the president of the Palestinian Authority of providing coverage of this holocaust in Gaza," Mashaal said. Hamas has said Abbas' condemnation of rocket fire has given a pretext to Israel's assault on Gaza.
Israeli officials met Saturday to discuss the Gaza violence and its implications for peacemaking. Foreign Ministry spokesman Arye Mekel said talks didn't preclude fighting. Talks are "based on the understanding that when advancing the peace process with pragmatic (Palestinian) sources, Israel will continue to fight terror that hurts its people," he said.
Vice Premier Haim Ramon told Channel 2 TV that Israel should fight in Gaza, but not reoccupy it. Israel pulled its troops and settlers out of the tiny seaside territory in late 2005, but militants proceeded to fire rockets from the abandoned territory at Israeli communities.
Hamas, which is sworn to Israel's destruction, took control of Gaza by force from the rival Fatah in June.
Israeli government spokesman David Baker said Israel was "compelled to continue to take these defensive measures" to protect more than 200,000 Israelis living under the threat of Palestinian rocket barrages.
Militants "hide behind their own civilians, using them as human shields, while actively targeting Israeli population centers," Baker said. "They bear the responsibility for the results."
Israeli military spokeswoman Maj. Avital Leibovich called Saturday's action a "pinpoint operation" provoked by the rocket attack on Ashkelon earlier in the week. She blamed the high civilian toll on Hamas' practice of using homes to store and produce projectiles.
"We are not targeting homes and we have no intentions of targeting uninvolved civilians," she said. "We will target launchers and Hamas militants, and bunkers."
Israeli-Palestinian peace talks, which had been in a deep freeze for seven years, resumed in November at a U.S.-sponsored conference. At the gathering, the two sides pledged to try to reach an accord by the end of this year. In recent weeks, negotiators have met almost daily.
But even when violence is at a lower level, Abbas' efforts are compromised by the fact that he only rules the West Bank, while Gaza is controlled by Hamas. And Israel's fragile government would be hard pressed to make concessions to the Palestinians while Gaza militants pummel southern Israel.