Two Israeli soldiers have been killed by a Hezbollah missile fired at at an Israeli military vehicle in the Shebaa farms area on the border with Syria and Lebanon.
The Israeli military confirmed that seven soldiers were also injured in Wednesday's strike.
In response to the attack, Israeli forces fired shells across the border into southern Lebanon, killing a UN peacekeeper from Spain. The United Nations Interim Force in Lebanon (UNIFIL) confirmed the death.
Responding to the attack, Israeli Prime Minister Benjamin Netanyahu promised those behind it would be held responsible.
"Those behind the attack today will pay the full price," Netanyahu said as he launched consultations with security chiefs on a possible further response to the incident, according to a Reuters news agency report.
There were also reports of Israeli war planes flying over the border with Lebanon.
A Hezbollah statement claiming responsibility for the attack said: "11:25am this morning, al-Quneitra Martyr's group targeted an Israeli convoy with specialised heavy duty rockets in the occupied Lebanese Shebaa farms area.
The convoy included Israeli artillery, an officer and several soldiers many of whom were injured," the statement read.
The attack by Hezbollah was likely in retaliation for an Israeli air strike in Quneitra on January 18th that killed six Hezbollah fighters and an Iranian general. Both Hezbollah and the Iranian army had vowed revenge, and earlier on Wednesday Iran said that Israel should "await retaliation" for the strike.
A Lebanese army spokesman said the missile was not fired from Lebanese territory, and that the artillery response by Israel was randomly falling on areas along the border, but that no shells had landed on villages with civilians yet.
Shebaa Farms is a small strip of disputed land at the intersection of the Lebanese-Syrian border and the Israeli-occupied Golan Heights.
Schools closed in and around Shebaa, and residents stayed indoors as the shelling continued throughout Wednesday morning.
Residents in neighbouring towns carried on as normal, telling Al Jazeera they did not feel things would escalate into full-blown war.
"Whatever happens happens, but we're not moving and we're not scared," one resident of Marjayoun, a town a few kilometres from the border with Israeli, said.
In a letter to the UN Security Council, Ron Prosor, the Israeli ambassador to the UN, condemned the attack, saying Hezbollah had been "stockpiling" weapons in southern Lebanon in violation of a UN resolution.
"Israel will not accept any attacks on its territory and it will exercise its right to self-defence and take all necessary measures to protect its population."
Al Jazeera's Nisreen el-Shamayleh, reporting from Jerusalem, said that while a response was expected from Israel against Hezbollah, an escalation of hostilities was unlikely.
Lebanese politician Samir Geagea, a member of the March 14 opposed to Hezbollah, said that the organisation "doesn't have the right to involve the Lebanese army and government in a battle with Israel."
Walid Jumblatt, another politician considered to be centrist, said the attack would lead to "turbulent" times for Lebanon.
On Friday, Hezbollah leader Hassan Nasrallah is expected to speak on the Quneitra strike.
In 2006, Israel fought a bloody war against Hezbollah that killed more than 1,200 people in Lebanon, mostly civilians, and some 160 Israelis, mostly soldiers.
With additional reporting by Nour Samaha. Follow her on Twitter: @nour_samaha .
Source: Al Jazeera and agencies