Israel's military said the incident began when "terrorists shot at a bus on its way to (the city of) Eilat and then fired an anti-tank rocket at another vehicle. At the same time, a military patrol hit an explosive device".
The Magen David Adom ambulance service said seven people were killed along the road, just meters from the porous border with Egypt. The military put the number of wounded at around 25.
Israeli special forces were called in and engaged the gunmen as police and military closed roads around Eilat, a popular Red Sea resort.
The military said seven gunmen were killed.
The violence, which began in the early afternoon, stretched into the evening. As the Israeli military's chief of staff and Defense Minister Ehud Barak were briefing reporters at the scene, ambulances raced away to what reporters said was another attack by gunmen in which two people were wounded.
"It was a grave terrorist incident that took place in several locations," Barak said in a statement. "It reflects the weakening of Egypt's hold in the Sinai and the broadening of activities by terror elements."
Calling the Gaza Strip, Palestinian territory controlled by Hamas and bordering the Sinai and Israel, "the source of terrorist activities", Barak said: "We will act against them with full force and determination."
Egypt's South Sinai Gov. Khaled Fouda denied gunmen had opened fire from Sinai. "The South Sinai governor denied there was any gunfire from Taba toward Eilat port," the Egyptian state television reported.
Gaza's Hamas government denied any role in the attacks. "The Palestinian government denies the accusations made by Barak about the operation in Eilat and affirms that there is no relation between the Gaza Strip and what happened near Eilat," Hamas spokesman Taher Al-Nunu said.
"These accusations are an attempt to distract from the Israeli domestic crisis," Al-Nunu said, referring to protests over the cost of living that have shaken Israel in recent weeks.
A senior Israeli official claimed the gunmen, unable to cross into Israel through the heavily patrolled border with the Gaza Strip, had gone into the Sinai and then infiltrated from there into southern Israel.
Israeli officials have voiced concern that armed groups in the Sinai have been making use of a security vacuum left by the overthrow of President Hosni Mubarak in February.
The Israeli shekel fell against the dollar and stocks dipped on Thursday.
Egypt, which signed a peace treaty with Israel in 1979, recently stepped up security activity in the Sinai. On Tuesday, Egyptian security sources said an army crackdown on armed groups in the northern Sinai had netted four militants as they prepared to blow up a gas pipeline. A network of smuggling tunnels links the area with the Gaza Strip.
Egyptian security sources said it was unlikely the gunmen had come from Egyptian territory. Security patrols on the Egyptian-Israeli border had not picked up on "suspicious movements" on the Egyptian side, a source said, adding that security had been heightened on the border after news of the incident.
