The attack came as Israel expanded the targets of its offensive to target homes of wanted militants.
It was the single deadliest incident of the five-day-old Israeli operation and is likely to raise international pressure for a halt to the offensive.
The airstrike targeted the home of the Daloo family in Gaza City's Nasser neighbourhood, reducing it to rubble.
Five women, including one 80-year-old, and four small children were among the dead, said Gaza health official Ashraf al-Kidra.
Frantic rescuers pulled the children's bodies from the ruins of the house, including a toddler and a five-year-old, as survivors and bystanders screamed in grief. Later, the bodies of the children were laid out in the morgue of Gaza City's Shifa Hospital.
The Israeli military said the target of the attack was a top rocket mastermind of the Islamic Jihad militant group. The claim could not be verified, and al-Kidra said the two men killed in the attack were also civilians.
The blast also damaged nearby buildings, and injured women and children were evacuated by ambulances.
The deaths brought to 66 the number of Palestinians killed in the Israeli offensive, including 32 civilians, said al-Kidra. Three Israeli civilians have also been killed in the fighting.
The attack came as an Israeli envoy flew to Cairo to hold talks with Egyptian officials on a ceasefire. Egypt has been leading international efforts to broker a truce.
The incident threatened to change the momentum of an offensive that Israel previously has said was going smoothly and according to plan.
The Israeli military says it has fine-tuned its weapons and tactics to avoid civilian casualties.
It also blames Palestinian militants for endangering civilians by storing and firing rockets from residential areas.
But the new tactic of hitting the family homes of suspected militant figures ran the risk of increasing civilian casualties. More than a dozen Hamas-linked houses were hit today. Some were empty after residents fled to find shelter elsewhere, but in several strikes, women, children and civilian men were killed or wounded.
Israel launched the offensive last Wednesday in a bid to end months of intensifying rocket fire from the Hamas-ruled Gaza Strip. After days of strikes on rocket launchers and storage sites, Israel announced earlier today that it was widening its campaign of airstrikes by targeting the homes of militant masterminds.
While claiming to inflict heavy damage on the militants, the rocket fire has continued uninterrupted.
As the offensive moved forward, Israel found itself at a crossroads - on the cusp of launching a ground offensive into Gaza to strike an even tougher blow against Hamas, or pursuing Egyptian-led truce efforts.
"The Israeli military is prepared to significantly expand the operation," Israeli prime minister Benjamin Netanyahu declared at the start of the weekly cabinet meeting.