The Israeli Defence Ministry blamed Monday's accident on a malfunction in the third stage of the Shavit rocket, which took off from an air base south of Tel Aviv.
Witnesses saw a flash of light near the coastal Palmahim base. There were no reports of casualties.
The Ofek-6 satellite - the latest in Israel's line of spy satellites - was destroyed when it crashed into the Mediterranean Sea.
The loss of the satellite is a major setback to Israel's attempts to upgrade its surveillance system to spy on enemies including Iran which it accuses of developing nuclear weapons. Iran denies the charges.
Israel's strategic defence systems are based on satellites designed to spot incoming missiles.
"Such incidents are very expensive for all involved," a defence source said.
In a terse statement, the Defence Ministry said "the source of the malfunction in the third stage is being investigated by experts from the Ministry of Defence and the involved industries".
The Ofek is a free-floating satellite that orbits 300km to 700km above the earth. It weighs about 300kg and its standard life span is about five years.
The setback came days after Israel's missile-killer system, the Arrow II, failed to shoot down a dummy missile in a test-firing off the California coast.
Israeli officials blamed a technical glitch on the failure of the missile to hit its target, but said the world's first missile-killer had passed the main reason for the test which was to identify the incoming missiles warhead.