The shooting on Thursday took place on bus 165, which shuttles between a Druze neighbourhood of the northern Israeli Arab town of Shafa Amr and nearby communities.
Four people were killed, including the driver. Police said the four apparently were all Shafa Amr residents.
Israel Radio said the gunman - who police said wore a skullcap, identifying him as an Orthodox Jew - was later bludgeoned to death by an angry crowd.
Medical sources said three of the wounded were listed as being in a in critical condition. Two policemen were among the wounded.
According to police sources, the shooter, who came from the West Bank settlement of Tapuah, had a brief argument with passengers about the imminent Israeli pullout from Gaza.
The argument got heated and ended up with him opening fire on the passengers.
"The gunman, Eden Tsuberi, was a 19-year-old soldier who was originally from Rishon Le Tzion (near Tel Aviv) and had recently turned to religion," Dan Ronen, police commander of the northern division, told public television.
"A despicable act by a bloodthirsty terrorist"
Israeli prime minister
The military identified the dead soldier as Private Eden Natan-Zada. His father, Yitzhak, said his son ran away from his army unit several weeks ago, after he was told he would have to participate in the Gaza pullout.
Israel is to evacuate all its settlements in the occupied Gaza Strip and four of 120 West Bank colonies beginning on 15 August.
Israeli intelligence and security forces had been warning that extremists might carry out attacks on Israeli Arab citizens or Palestinians in the West Bank to foil the withdrawal.
Israeli Police Commissioner Moshe Karadi warned that the shooting could trigger more violence.
Following the incident, police deployed additional forces in Shafa Amr to forestall possible riots.
The Jerusalem police raised their alert level and were to increase forces in the city.
Fearing "provocation" and rioting by Muslims who pray
on Fridays at Jerusalem's al-Aqsa mosque, police decided to increase presence in the narrow alleys and streets of the Old City, spokesman Shmulik Ben-Ruby said.
Israeli Prime Minister Ariel Sharon denounced the shooting
as "a despicable act by a bloodthirsty terrorist" and
ordered police to give top priority to the investigation.
Palestinian leader Mahmoud Abbas called on Israel to prevent Jewish settlers from carrying weapons "because they are dangerous to the security and peace between the two people".
The soldier had talked about the
withdrawal before opening fire
Settler leaders also condemned the attack. A statement by the Yesha Council, which represents Jewish settlers in the West Bank and Gaza, described the incident as "an act of a madman".
The attack was strongly condemned by the leaders of the Israeli Arab community, who make up to 22% of Israel's total population.
Muhammad Baraka, a member of the Israeli parliament, the Knesset, condemned the "terrorist attack".
"We are witnessing attempts by extreme right-wing people - terrorists - who want to set the region ablaze and feel they have freedom of action in light of the behaviour of the security, political and judicial establishment," Baraka told Israeli Radio.
Arab Knesset member Ahmed Teibi called the incident a "real carnage".
"This is the inevitable outcome of years of racist and fascist incitement against every thing and anything Arab."
"This is the inevitable outcome of years of racist and fascist incitement against every thing and anything Arab"
Israeli Arab Knesset member
Teibi, in a telephone interview with Aljazeera.net, lambasted Israeli officials and settler leaders who argued that the incident was isolated.
"You see, these forces of darkness have become a central current among Jews in Israel. The fascists simply moved from the streets to the Knesset to become ministers and government officials," he said.
Teibi said the settler soldier was inculcated with hatred for Arabs and Muslim, adding that what he did was a natural outcome of a fascist indoctrination.
"This settler epitomises a large and widespread culture in Israel the foundation of which is hatred to every thing Arab.
"He saw how the police shot 13 Arab citizens in October 2000 and how the killers remained free, so he has done the same thing, thinking that an Arab can be killed with impunity."