The home-made missile landed in open ground in the West Bank, to the south-east of the Israeli capital.
Air raid sirens were triggered and panic broke out in the city for the first time since the Gulf War in 1991.
Jerusalem is about 72km from Gaza. Until recently it was not thought to be in range of Hamas rockets.
The targeting of the holy city with a home-made 'M75' missile, which landed in open ground in the West Bank, represented a major escalation in the fighting as the Israeli Defence Force also continued to bombard all parts of the Gaza strip throughout yesterday.
In all, 23 Palestinians have been killed, including 12 militants and six children, according to the most detailed accounts. Three Israelis have died, including a pregnant woman.
Benjamin Netanyahu, the Israeli prime minister, met military leaders last night to discuss a ground offensive inside Gaza. They will find it hard to ignore appeals for action.
Israeli armed forces appeared to be preparing for a ground assault as they sealed off major roads leading to the territory while tens of thousands of extra reservists were called up.
Israel's defence minister Ehud Barak said he was giving approval for 75,000 reservists to be enlisted, up from 30,000 on Thursday. Of those, 16,000 are already in uniform, as infantry troops joined rows of trucks, bulldozers and tanks along the border. "The Israeli military continues to strike hard against Hamas and is prepared to expand its action into Gaza," Mr Netanyahu said.
The Palestinian militant group rejected calls to scale down its rocket attacks. "We are sending a short and simple message," said a Hamas spokesman named as Abu Obeida. "There is no security for any Zionist on any single inch of Palestine and we plan more surprises."
The day was marked by inflammatory strikes by both sides, despite a visit to Gaza by the Egyptian prime minister, Hisham Qandil, who is at the centre of attemptsto bring the violence to a halt.
William Hague, the British foreign secretary, said: "When Israel has entered into ground invasions in other conflicts that is when they have lost a good deal of international sympathy and support, and of course civilian casualties become much harder to avoid."
"I tell them in the name of all the Egyptian people that the Egypt of today is not the Egypt of yesterday and that the Arabs of today are different than the Arabs of yesterday," he said. "Cairo will not leave Gaza on its own."