The man "was shot dead by the soldiers and a bomb of several kilogrammes was found beside him," an army spokesman told Agence France Presse.
After the body was handed over to the Palestinian authorities, the man was identified as 27-year-old Nihad Raziq, a member of the al-Aqsa Martyrs' Brigades.
The armed offshoot of Yasir Arafat's mainstream Fatah has a loose hierarchical structure and its official adherence to the truce declared by other Palestinian resistance groups on 29 June was never accepted by some local branches.
Raziq, who was also a member of a branch of the Palestinian security services, was wanted by the Israeli army over his involvement in anti-Israeli attacks.
Attack on settler family
The al-Aqsa Martyrs Brigades had claimed responsibility for a gun attack on Sunday on a car in southern Jerusalem that wounded an Israeli woman and her three children.
3388 people have
been killed since the start of the intifada
at the end of September 2000, including
and 774 Israelis
"A unit of our brigades set up an ambush for Zionist settlers near the village of Ouallaja and, when their vehicle passed our fighters they opened fire on it, hitting several of them," the group said in a statement, vowing to "pursue resistance operations".
Israeli emergency service officials said the four Israelis were wounded when a burst of gunfire hit their car near the entrance to Gilo, a Jewish settlement built on Pallestinian land annexed after the 1967 Middle East war.