Lebanese guerrillas have captured two Israeli soldiers in a cross-border raid, triggering the first Israeli land incursion into the country since 2000.
Israel says it is planning to retaliate against Lebanon
Planes struck outposts of the Hezbollah militant group in south Lebanon, as well as roads, killing two civilians.
Israel has called up reserve troops, signalling a large-scale campaign, as operations continue to free a soldier seized by Palestinians in Gaza in June.
Israel's PM Ehud Olmert said the attack was an "act of war" by Lebanon.
Mr Olmert has said he holds Lebanon responsible for the fate of the two soldiers and that it would pay a "heavy price".
The prime minister has called an emergency cabinet meeting to discuss further action, although he has already ruled out negotiations.
"The Lebanese government, of which Hezbollah is a part, is trying to shake regional stability," he said at a press conference in Jerusalem.
"We are already responding with great strength," he said, threatening "very painful and far-reaching" action.
Israeli ground troops have entered southern Lebanon to search for the two soldiers, for the first time since Israel ended its occupation of south Lebanon six years ago.
Several thousand reservists will be deployed along the border, officials say.
The news of the clashes comes as a major Israeli offensive is under way in the Gaza Strip. An Israeli soldier was kidnapped by Palestinian militants in Israel over two weeks ago.
Overnight, Israel carried out an air strike on a Gaza City house, killing at least six people and injuring 15.
On Wednesday morning, Hezbollah launched dozens of Katyusha rockets and mortar bombs at the Israeli town of Shlomi and at Israeli outposts in the Shebaa Farms area.
Later on Wednesday, Hezbollah said its fighters had destroyed an Israeli tank attempting to cross the border. An Israeli military spokeswoman said there had been a number of casualties.
Two civilians were killed when Israeli planes bombed a road bridge on major route though southern Lebanon.
Civilians in northern Israel have been told to stay in their shelters.
The UN representative in Lebanon, Geir Pedrson, has condemned the escalation and called on Hezbollah to release the soldiers.
Call for swap
Hezbollah said it captured the two Israeli soldiers at 0904 (0704 GMT).
A statement from the group said the two were taken to a "safe place". It did not mention whether they were alive or dead or injured.
The group says it has captured the soldiers to secure the release of detainees held in Israeli prisons.
"Fulfilling its pledge to liberate the prisoners and detainees, the Islamic Resistance... captured two Israeli soldiers at the border with occupied Palestine," the Hezbollah statement said.
Hezbollah captured three Israeli soldiers in 2000. They died during the operation, but four years later, the group was able to exchange their bodies for 430 Palestinians and Lebanese held in Israeli jails.
BBC Middle East analyst Roger Hardy says the capture of two Israeli soldiers is a dramatic gesture of solidarity with the Palestinians - and at the same time adds to the pressures on the Israeli government.
Complicating the picture is the fact that the Lebanese group has the backing of both Syria and Iran.
Israel and American officials are already saying Syria must bear some of the blame for the capture of a young Israeli soldier in Gaza last month - because it plays host to part of the Hamas leadership.
Pressure on Syria - as well as on the Lebanese government - will now intensify, our analyst adds.