JERUSALEM (AP) _ An Israeli tank shelled a hotel in biblical Bethlehem on Friday, after Palestinian gunmen fired at Israeli troops at an enclave in the West Bank town. The exchange came despite high-level Israeli-Palestinian truce talks.

Elsewhere in the West Bank, an Israeli motorist was killed in a daylight ambush and an activist in Palestinian leader Yasser Arafat's Fatah movement was shot and killed in what Palestinians said was an attack by Israeli troops tracking gunmen.

In the town of Nablus, thousands of Palestinians attended the funeral of Ibrahim Bani Odeh, a suspected Islamic militant bombmaker who, Palestinians say, was assassinated by Israel on Thursday. Bani Odeh's Hamas group pledged revenge.

``Our response will be more car bombs and they (the Israelis) will pay a high price,'' said the Hamas leader in Nablus, Sheik Hamed Bitawi. On Wednesday, two Israelis were killed and more than 60 wounded in a car bomb attack in the northern Israeli town of Hadera. The bombing was widely blamed on Islamic militants.

In Bethlehem, Jesus' traditional birthplace just south of Jerusalem, dozens of Palestinians on Friday threw stones at Rachel's Tomb, a heavily guarded Israeli enclave, the army said. Eventually, Palestinian gunmen opened fire on Rachel's Tomb, Israeli troops returned fire, and a battle ensued.

At one point, Israeli tanks fired two shells at the Paradise Hotel in Bethlehem, damaging the fourth and fifth floors. Israel radio said gunmen were shooting from the hotel, a charge denied by Ibrahim al-Atrash, a hotel employee. Six Palestinian passers-by were hurt by shrapnel.

At the time of the shelling, there were no guests in the hotel, al-Atrash said. Like all other Palestinian towns in the West Bank and Gaza Strip, Bethlehem has been under Israeli blockade for five days, with no one allowed to leave and enter.

The shelling came despite a decision by Israel's security Cabinet late Thursday to scale down retaliation for Palestinian attacks, taking into account the damage to its international standing from massive air strikes.

The security Cabinet approved ``a full list of operations,'' Ephraim Sneh, Israel's deputy defense minister, told Israel radio. He said Israel's response would be aimed to prevent attacks or ``punish terrorists for attacks they carried out, while causing us the least possible diplomatic damage.''

After Israel retaliated for a bomb attack on a school bus Monday with a massive rocket barrage against Gaza City, Egypt recalled its ambassador, Jordan delayed sending a new envoy, and the United States harshly criticized Israel for using excessive force.

Before the Cabinet session, Sneh met with two senior Palestinian officials at an Israel-Gaza crossing point, despite an earlier bomb attack on a Gaza liaison post. Both sides said the subject was stopping eight weeks of violence.

Col. Pini Levy, a senior Israeli commander in Gaza, said his forces would move against armed Palestinians, indicating that special operations could be carried out inside Palestinian-controlled territory.

In the night from Thursday to Friday, 120 Palestinian activists were arrested by Israeli troops and the Shin Bet security service in the northern West Bank, said a regional Israeli police commander, Avi Feder.

Also Friday, a 15-year-old Palestinian boy died of wound sustained last week in a clash with Israeli troops at the Karni crossing between Gaza and Israel. In all, 265 people have been killed in two months of fighting, the vast majority Palestinians.

Israel said Palestinian attacks on Israelis must stop before peace talks can resume. ``Stopping abruptly the terrorist violence is ... an indispensable condition for resumption of talks and going back on the track of peace,'' said Sneh.

Arafat expressed hope that a truce could be reached.

``We are sure that we will be able to find a solution that is successful,'' Arafat told reporters after arriving in Moscow for a meeting with Russian President Vladimir Putin. Arafat wants Russia to take a more active role as a mediator, over U.S. and Israeli objections.