State television footage taken after the blast showed a scene of bloodied bodies lying in a jungle clearing, among strewn suitcases and bags of personal belongings.
The military has pushed the Tamil Tigers, who are fighting for a homeland for ethnic Tamils in the north and east of the island, back into a small sliver of jungle on the east coast.
It says that the area under the separatists' control has been reduced to less than 100sq km by the latest military offensive.
Ashok Mehta, a retired Indian army general who has served in Sri Lanka, told Al Jazeera: "It is a matter of time, in fact days, before they [the government] are able to declare mission accomplished."
However, he warned that taking control of Tiger territory is "just the end of the conventional phase of the conflict" as government forces would then seek to flush out armed separatists hiding in the region until they are in a position to resume fighting.
"We deplore the loss of civilian life in this targeted killing. It's a blow for people who have suffered so much"
UN resident co-ordinator
More than 20,000 civilians have reportedly fled the area in the past few days, heading for government-declared "safe zones" as the two sides have continued to bombard each other with artillery fire.
"We expect many more to come in the next few days, despite the suicide attack," Mahinda Samarasinghe, Sri Lanka's human rights minister, said.
The United Nations and aid agencies have expressed concern for the estimated 250,000 civilians that were living in the area before the military pushed the remaining Tamil Tiger fighters back to the area.
The government has disputed the figures, saying that there are only 120,000 people in the war zone and that they are doing their best to avoid civilian casualties.
Al Jazeera's David Hawkins, reporting from Sri Lanka, said the government had been criticised for putting civilians who left the war zone into military camps.
"[Government officials] say they have to check the civilians very carefully to make sure Tamil Tiger fighters are not trying to sneak out along with them," he said.
"This suicide bomb attack shows that those concerns are legitimate."
Nanayakkara said that the Tamil Tigers had carried out two previous suicide attacks in the past week.
The Liberation Tigers of Tamil Eelam did not immediately confirm or deny the military's claims and it is impossible to independently verify the reports as journalists are banned from the conflict zone.
However, the United Nations condemned the reported bombing.
"We deplore the loss of civilian life in this targeted killing. It's a blow for people who have suffered so much," Neil Buhne, the UN resident co-ordinator, said.
The Tamil Tigers have been accused of more than 200 suicide attacks in Sri Lanka and are listed as a "terrorist" group by the US and the European Union.
International organisations including the Red Cross have urged both sides to let non-combatants out of the conflict zone.
"We are talking to both parties to the conflict to secure a safe passage by sea to evacuate about 400 patients," Sophie Romanens, ICRC spokeswoman, said on Monday.
The government, aid agencies and rights groups have accused the rebels of forcibly keeping people in the war zone as human shields, conscripts and labourers, which the Tigers deny.