Al Jazeera's correspondent in Gaza, Nour Odeh, said the children lived in the area and were members of the same extended family.
Witnesses said they were playing and collecting scrap metal in the area, which could have included rocket launchers left by armed Palestinian groups.
A relative of the children, Wasfi Ghazal, said he heard the sound of an explosion and then children screaming. He held both Israel and the militant rocket squads responsible.
"We are victims of the occupation and victims of the misbehaviour of some of the fighters who are randomly choosing our area to target Israel," he said.
Palestinian negotiator Saeb Erekat, also an adviser to Mahmoud Abbas, the Palestinian president, said the killing of children is unjustifiable, and condemned it in the "strongest possible terms".
"I think violence breads more violence, and hatred. This will add to the complexities and feed the fire," he said.
In Gaza, Taher Nunu, a Hamas spokesman, called the Israeli attack a "war crime" and called on Abbas to halt his meetings with Ehud Olmert, the Israeli prime minister. The two met on Tuesday.