Troops raiding the outlying al-Faraa refugee camp exchanged fire with three fighters holed up in a camp mosque at dawn, the Israeli army and Palestinian officials said on Thursday.
 
The army said the three men opened fire at troops from inside the mosque, and that soldiers returned fire.
 
People confined
 
Inside Nablus, Israeli soldiers left the narrow stone alleyways of the old town, where the operation had centred since it began on Sunday, lifting a curfew that confined tens of thousands of Palestinians to their homes.
 
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The Israeli forces regrouped around an apartment building in a newer neighbourhood, surrounding it with jeeps and armoured vehicles, using loudspeakers to demand the surrender of wanted men thought to be hiding in the building.
 
After civilians poured out, soldiers rushed through the entrance and explosions were heard inside, but it was not immediately clear whether armed men were holed up there.
 
The Israeli troops later withdrew to the outskirts of the city, Palestinian security sources said.
 
Soldiers pulled out in the afternoon but nevertheless remained in position on the outskirts of Nablus, the sources said.
 
The Israeli military says that 10 wanted fighters have been arrested since the operation began.
 
One Palestinian civilian has been killed.
 
In another development on Thursday, suspected Palestinian fighters shot and wounded an Israeli settler driving through the occupied West Bank, medical sources said.
 
The 55-year-old man from Tzofim settlement near the West Bank town of Qalqilya was "evacuated to hospital with light to moderate  wounds", Yerucham Mandola, a Magen David Adom rescue services spokesman, said.
 
The Israeli army said it was searching for the assailants.
 
Israeli reservations
 
Meanwhile, Tzipi Livni, the Israeli foreign minister, has said Israel cannot accept an Arab peace initiative as it stands, according to an interview published in a Palestinian daily on Thursday.

Thousands are confined to their homes as Israel
strikes Nablus's "terrorist infrastructure" [AFP]
She told Al-Ayyam that Arab countries had introduced new clauses to the Saudi peace initiative on the fate of Palestinian  refugees making it "impossible to accept in its current form".

Under the plan, adopted by the Arab League at a summit in 2002,  the Arab world would normalise ties with Israel in exchange for a full withdrawal from Arab land occupied since 1967 and the  establishment of a Palestinian state.

Livni said: "The idea of establishing full diplomatic relations between  Israel and the Arab countries is part of our ambitions ... I think we  have a common objective and that our differences are lessening."

"The Saudi initiative was initially a positive sign but since  the hardliners in Beirut added points going against a solution based  on two states, it has become unacceptable to us in its current form."