Israel is preparing to wage war against Hamas in the very heart of Gaza's crowded population centres unless the Islamic militants accept ceasefire demands swiftly and stop firing rockets over the border.

As thousands of reservists pour into Gaza to bolster Israel's forces, the Cabinet is expected to approve imminently a devastating new “third phase” of its 18-day-old offensive unless there is a last-minute diplomatic breakthrough.

Ehud Olmert, the Israeli Prime Minister, pledged yesterday to hit Hamas with an “iron fist” if the rockets did not cease.

“We will continue for as much time as is necessary in order to remove this threat,” he declared in a speech in Ashkelon, a town regularly hit by rockets. “We cannot be soft. It is us or them ... We will continue striking with all our might, with all our power, until there is quiet.”

Mark Regev, the Israeli government spokesman, said that Hamas fighters were taking “serious punishment” and Israel was “advancing towards the endgame”. A senior defence official said that Israel was laying the groundwork for a big increase in its offensive, and that the military was ready to move the moment the political leadership approved.

Another military official closely involved in the operation said that Israeli troops in Gaza had been ordered to engage with maximum force over the past 24 hours. That, and the deployment of the reservists to free regular troops by taking over territory already secured, was designed to increase the pressure on a Hamas leadership increasingly divided over whether to continue fighting.

The Israeli Government believes Hamas has been stunned by the ferocity of Operation Cast Lead, and that there are splits emerging between the political and military wings in Gaza, and between top Hamas members in Gaza and those in Damascus where Khaled Mashal, the group's exiled leader, lives. The Israeli media, however, also reports splits in the Israeli leadership. Tzipi Livni, the Foreign Minister, and Ehud Barak, the Defence Minister, are reported to be more reluctant than Mr Olmert to approve an expansion that could result in many Israeli casualties. Ms Livni and Mr Barak face a general election next month while Mr Olmert is standing down.

In the past two days Israeli ground troops have engaged in some of the fiercest fighting so far on the outskirts of Gaza City. The death toll has risen past 900, with women and children accounting for nearly 400 of the dead. The UN Human Rights Council yesterday voted 33-1 — with 13 Western countries abstaining — for a resolution accusing Israel of grave human rights violations and urging a fact-finding mission.

Israeli analysts say a ground war fought in the narrow streets and alleys of Gaza City and other urban centres would make the conflict to date seem tame. “The Israel Defence Forces will enter, with great force, with tens of thousands of soldiers, into the heart of the Palestinian population in the Gaza Strip,” the respected commentator Alex Fishman wrote in yesterday's Yedioth Ahronoth newspaper.

“There will no longer be strikes at the margins from the ground and destruction from the air. Now we are talking about armoured divisions that will not leave a single stone standing on their way into the refugee camps and into the heart of one of the most crowded cities on Earth.” Israel's minimum demands for accepting an Egyptian-brokered ceasefire are a permanent cessation of Hamas rocket attacks and internationally enforced mechanisms to guarantee that Hamas can no longer smuggle in weapons through Gaza's southern border with Egypt. Hamas wants an end to Israel's blockade of the Gaza Strip with the opening of its border crossings.

David Miliband, Britain's Foreign Secretary, told MPs after being briefed on the Cairo talks: “There are some people in Hamas who recognise that there needs to be a politically negotiated solution. However, the tragedy is they are not in the majority.”

Amos Gilad, Israel's top negotiator, postponed a visit to Cairo yesterday until Hamas's position became clearer. Tony Blair, the International Middle East envoy, said after talks with President Mubarak of Egypt that the elements of an agreement were in place. “I hope we can achieve it within the coming days.”

Ismail Haniya, the head of the Hamas Government in the Gaza Strip, told his people in a televised address: “We are approaching victory ... The blood which has flowed will not have flowed in vain ... I tell you that after 17 days of this foolish war, Gaza has not been broken and Gaza will not fall.”

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