Two Israeli soldiers have been killed in a Hezbollah strike on an army convoy near the Lebanese border, the military said.
Another seven soldiers were wounded in the attack, officials said, and Israel's military responded to the anti-tank missile attack with aerial and ground attacks on Hezbollah positions in Lebanon.
A Spanish United Nations peacekeeper was killed in the clashes.
The Lebanese Hezbollah group said it fired the missile and Israel replied with at least 50 artillery shells into Lebanon in a significant escalation along the volatile border.
Hezbollah said its fighters destroyed a number of vehicles carrying Israeli officers and soldiers and caused casualties among "enemy ranks".
It said the attack was carried out by a group calling itself the "heroic martyrs of Quneitra", suggesting it was retaliation for an Israeli air strike on the Golan Heights on January 18 that killed six Hezbollah fighters and an Iranian general.
The attack took place near Mount Dov and Shebaa Farms, a disputed tract of land where the borders of Israel, Lebanon and Syria meet.
Two Lebanese officials said the Israeli shelling targeted the border villages of Majidiyeh, Abbasiyeh and Kfar Chouba, near the Shebaa Farms area.
Families living on the border of the villages fled, Lebanese officials said.
One of the officials said the incident was a "sophisticated Hezbollah operation" targeting Israeli vehicles along the border.
The attack came shortly after Israel launched air strikes targeting Syrian army artillery posts in response to rockets fired the previous day into the Israeli-held Golan Heights.
Israel has declined to comment on any connection to the January 18 air strike, but has braced for a response to the strike, beefing up its air defences and increasing surveillance along its northern frontier.
Israel says the Chebaa Farms is part of the Golan Heights, which it captured from Syria in 1967. Lebanon and Syria say the enclave belongs to Lebanon, while the United Nations says the area is part of Syria and that Damascus and Israel should negotiate its fate.
The latest salvos raised the possibility of renewed fighting along the Lebanese-Israel border, which has remained mostly quiet since a month-long war in summer 2006. Since then, Israel has responded with air strikes and artillery fire following a number of rocket attacks and shootings but the violence remained contained.
The violence was the deadliest Hezbollah attack against Israeli forces since the 2006 war between the two sides.
Israeli prime minister Benjamin Netanyahu said Israel would respond "forcefully" to the attack.
About an hour after the missile attack, mortars were fired at several Israeli military locations on Mount Dov and Mount Hermon, the Israeli military said. No injuries were reported in that attack. The military said it responded with fire towards Lebanese positions, and evacuated Israeli visitors from a ski resort in the area.
The flare-up recalled the beginning of the month-long 2006 war, which was sparked by a Hezbollah attack on an Israeli military vehicle along the border and the kidnapping and killing of two Israeli soldiers.
The Israeli military said there was no indication that any Israeli soldiers were captured in today's attack.
The Spanish Defence Ministry identified the dead peacekeeper as Corporal Francisco Javier Soria Toledo, 36. Foreign minister Jose Manuel Garcia-Margallo told reporters he had received a phone call from Israel's ambassador to Spain, offering condolences.
In a statement, Israel's foreign minister Avigdor Lieberman said he had conveyed Israel's condolences for the death in a conversation with his Spanish counterpart.
Mr Netanyahu, speaking at an event in southern Israel, warned that Israel's enemies would face a fate similar to Hamas, the rulers of the Gaza Strip who fought a brutal 50-day war against Israel last summer.