Israel defied a Tuesday deadline set by Gaza militants for the release of Palestinian prisoners and warned Hamas leaders the "sky will fall on them" if an abducted Israeli soldier is harmed.
Gilad Shalit was seized in a cross-border raid in late June.
With Israeli tanks and infantry massing along the Gaza Strip's northern border, Prime Minister Ehud Olmert said the campaign launched last week to free Corporal Gilad Shalit could turn into "a long war".
Increasing political pressure on Olmert to launch a broad ground offensive, Palestinian militants carried out their deepest rocket attack yet against Israel, hitting a school yard in the coastal city of Ashkelon, causing no injuries.
Israel rejected a 4am (Irish time) ultimatum set by three militant factions, among them the Hamas armed wing, to begin freeing 1,000 Palestinian prisoners, as well as jailed women and youths, in exchange for Shalit.
The factions vowed not to release any information about the soldier and pulled out of negotiations with Egyptian mediators trying to end the standoff, a Hamas political leader said.
But Palestinian Prime Minister Ismail Haniyeh of Hamas called on the factions to return to the negotiating table, putting himself at odds with militants who said further discussions over Shalit's fate were out of the question.
The factions had warned Israel that it will "bear full responsibility for future consequences" if their prisoner swap demands were not met.
Israeli Prime Minister Ehud Olmert
Israel has given the army a green light to launch a deeper incursion into northern Gaza, though there was no indication when it might begin.
"Hamas well understands ... that the sky will fall on them if they harm Gilad Shalit," Israeli Interior Minister Roni Bar-On said.
"This is a long war," Olmert said. "It requires lots of patience, sometimes endless restraint. We have to know when to clench our teeth and to deal a decisive blow."
Israel has said it will hold moderate Palestinian President Mohammed Abbas and the Hamas-led Palestinian Authority (PA) responsible for Shalit's safety.
It has also hinted it could assassinate leaders of Hamas, whose government is under an international aid embargo, if Shalit is not freed.
Israeli security sources said a commando raid to try to rescue Shalit remained an option but would be risky in Gaza's maze of alleyways. The last Israeli soldier abducted by Palestinians was killed in a failed rescue bid in 1994.