The price fell sharply after Israel's Channel 10 television cited a senior military official stating that Israel could end its Lebanon offensive within days.
The Israeli government quickly denied the report, but it was enough to prompt a round of profit-taking after a four-day rally on oil.
Concern that the conflict could spill over to neighbouring countries and affect Middle East oil supply earlier sent London Brent crude to a record high.
Brent for September was down $1.31 at $76.27 a barrel by 1602 GMT, after touching a record $78.18 a barrel early in the session.
US light crude was down $1.38 at $75.65 a barrel, nearly $3 below the high of $78.40 hit on Friday.
Eoin O'Callaghan, economist at BNP Paribas, said: "Given the importance of geopolitics to the market at the moment, prices will see-saw with the news flow."
"There has been so much geopolitical news in so short a time that you are going to get large fluctuations in prices as the news flow changes."
Neither Israel nor Lebanon are oil producers, but both lie at the heart of the Middle East, which collectively pumps nearly a third of global output.
Washington-based energy consultants PFC said in a report: "The crisis has quickly taken on a regional hue, with both Washington and Tel Aviv accusing Iran and Syria of orchestrating the attacks.
"As a result, US policy toward Tehran is likely to harden even further, and could undermine already fraught efforts to resolve the Iranian uranium enrichment issue diplomatically."
Experts say oil prices will fluctuate
along with the Middle East crisis
In Iraq, a country scrambling to restore its oil exports to pre-war levels, the head of its North Oil Company was kidnapped in the capital, the second high-profile abduction in two days.
Analysts saw no let-up in prices in the near term.
"We would expect front-month prices to rise above $80 this quarter," said O'Callaghan.
"There is plenty to keep prices inflated. On the one hand geopolitics, and on the other fundamentals are tight. And we also have the possibility of hurricanes."
Shortage of oil
Opec said on Friday that high prices and slower economic expansion would moderate global oil demand growth next year.
Opec economists forecast oil demand would rise by 1.3 million barrels per day, down from 1.4 million bpd in 2006.
The producer group expects the need for its oil to fall next year as more projects from rival suppliers come on line, allowing Opec to rebuild its spare capacity.
A senior OPEC delegate on Monday said the group could do nothing to lower oil prices as they are being driven by Middle East violence rather than any shortage of oil.