Also Sunday, a 7-year-old Palestinian boy was killed and his 6-year-old brother were wounded by army fire while playing near a military outpost on the outskirts of the Rafah refugee camp in southern Gaza, relatives said. The military said no forces were in the area at the time, but that it would continue to look into the incident.
Defense Minister Shaul Mofaz revealed he is not ruling out a reoccupation of the entire Gaza Strip, home to more than 1 million Palestinians.
U.S. Secretary of State Colin Powell said the creation of a "democratic, viable" Palestinian state is possible in 2005 if the Palestinians "clamp down on terrorism." But he said Israel must stop building settlements in the West Bank and Gaza Strip.
"A Palestinian state, when it's created, must be a real state, not a phony state that's diced into a thousand different pieces," Powell said in an address at the annual meeting of the World Economic Forum in Davos, Switzerland.
The Palestinians accused Prime Minister Ariel Sharon of ordering the raid — the deepest into Gaza City in more than two years of fighting — to win more votes.
They said only seven of about 130 shops and businesses destroyed in the raid were metal workshops. The military said troops destroyed more than 100 lathes used for making weapons and several rockets and anti-tank missiles were discovered.
The military said it was completely sealing the West Bank and Gaza Strip for three days to prevent Palestinian militants from sabotaging Tuesday's election. Stringent travel bans have been enforced since the outbreak of fighting in September 2000, and the new restrictions, to take effect Sunday, mean all Palestinians are confined to their towns and unable to enter Israel.
The Gaza City raid began shortly after 10 p.m. Saturday, and ended Sunday morning. After Israeli troops withdrew, about 30,000 Palestinians joined the funeral procession for the 12 gunmen killed in the fighting — the highest death toll in Gaza in five months. Those killed included members of the security forces and various Palestinian militias.
Hospital officials said 67 people, including about 20 civilians, were wounded, 12 critically. It was the bloodiest day in the Gaza Strip since August, when 13 people were killed in an Israeli attack on the southern city of Khan Younis.
"The Israelis will pay a heavy price for every drop of blood shed last night," Abdel Aziz Rantisi, a leader of the Islamic militant group Hamas, said at the funeral. "Our battle will continue until we uproot this Zionist occupation from our holy land, no matter what the sacrifice."
Hamas and other Palestinian factions are attending Egyptian-sponsored talks in Cairo on halting attacks on Israeli civilians for a year, but chances of reaching agreement appeared slim. Hamas and its smaller sister group, Islamic Jihad, have said they would not agree to a cease-fire.
The Gaza City raid came in response to the firing of crude, short-range Qassam rockets on the Israeli town of Sderot in the southern Negev Desert, near Gaza, on Friday.
Israeli troops later entered the northern Gaza town of Beit Hanoun, the source of the rocket fire. On Sunday morning, nine Israeli tanks took up positions in the town center early.
The Israeli defense minister said that for now his aim was to stop the firing of rockets at Israeli towns, but he was not ruling out reoccupying all of Gaza.
"We need to keep all our options open, including the option of taking over the strip," Mofaz told Israel Radio.
Israel's opposition leader, Amram Mitzna of the center-left Labor party, has said he would order an immediate withdrawal of Israeli soldiers and settlers from Gaza, if elected prime minister. However, Labor is trailing, and Sharon is expected to keep his job, albeit as leader of a relatively unstable right-wing government if Mitzna sticks to a pledge not to join a Sharon-led coalition.
Palestinian Cabinet minister Saeb Erekat said the Gaza raid was driven by Israeli politics. "We believe he wanted to end the election campaign on this note with more Palestinian blood and destruction," he said.
The incursion began with columns of tanks driving into Gaza City from three directions. Tanks stopped only about 300 yards from Palestine Square, which marks the center of the city of about 300,000.
Helicopter gunships fired machine guns at buildings and at crowds in the streets, including gunmen, witnesses and security officials said. Israeli forces also blew up two three-story houses of Hamas militants involved in attacks on Israelis. A missile fired by an Israeli helicopter set a huge fire in an industrial area in eastern Gaza City. The blaze destroyed dozens of shops.
An army officer, identified on Israel Radio only as Lt.-Col. Ron, described a night of door-to-door fighting, much of it in residential neighborhoods, against Palestinians firing automatic weapons and anti-tank missiles.
"It started with sporadic opposition, but when they realized that we were entering in a big way, they started organizing, and we saw in the course of the night they started to organize themselves in a much more orderly way," he told the radio.
In the West Bank, a donkey loaded with explosives blew up near an army checkpoint near Bethlehem but caused no casualties, police said. It was not immediately clear if the animal was meant to explode near the troops or if it was transporting a bomb that exploded prematurely.