The battle between Sri Lankan forces and Tamil separatists for control of a waterway near the country's north-eastern coast threatened to escalate into a full-scale war as jets hit rebel positions and a fierce naval battle saw shells traded in the port of Trincomalee.

In some of the heaviest fighting since the Tamil Tigers surrounded the reservoir that supplies nearby villages with water for drinking and irrigation 12 days ago, the Sri Lankan forces launched an offensive with Israeli-built Kfir jets carrying out bombing sorties and soldiers advancing through minefields into rebel territory.

In response a flotilla of Tamil rebel boats and artillery positions exchanged shells with a navy ship ferrying 850 soldiers to shore. The TamilNet website said the rebels had destroyed a government boat, killing eight sailors. They also said they had killed a further six sailors after firing artillery at an adjoining navy base.

The Sri Lankan military denied the claims. "We have destroyed three terrorist boats after coming under attack from Tiger artillery and mortar," a spokesman for the army told the Guardian.

The battles mark a step change for the Sri Lankan military. This is the first ground offensive since the 2002 ceasefire. The air force has conducted seven consecutive days of aerial bombings on rebel positions in the east.

Although the high command of both sides claim the ceasefire is holding, the death toll is rising steadily. A roadside bomb exploded near a military truck in Trincomalee killing 18 soldiers late on Monday, bringing the death toll on one day in the "water war" to more than 70, the military said.

The north-east of the island is split into government and rebel-held areas. Tamil Tigers accuse the Colombo authorities of reneging on a pledge to build a water tower for people living in rebel-held areas and have shut a key sluice gate that supplies water to government-held areas.

More than 65,000 people were killed in the two-decade civil war launched by the Liberation Tigers of Tamil Ealam in 1983. Both sides agreed to a ceasefire brokered by Norwegian diplomats four years ago. But renewed fighting has killed more than 800 people - half of them civilians - since the beginning of the year.

Monitors say that since no one has "declared war" they take the latest bloody turn of events to be a "gross violation" of the ceasefire. "We have told both sides that the military solution is wrong but they choose not to listen," said Thorfinnur Omarsson, a spokesman for the Sri Lanka Monitoring Mission. "Both the LTTE and the government are escalating military actions, which is a threat to the whole country."

On Monday the head of the monitoring mission warned of an impending disaster. "In reality, there is no ceasefire agreement in this area in Trincomalee today, but the paper is still valid," said Ulf Henricsson, the retired Swedish general in charge of the mission. "A full-scale war will be a disaster for both sides."

The SLMM's role is likely to be much reduced in the coming weeks. Sweden yesterday signalled it would withdraw staff from Sri Lanka following the departure of Danish and Finnish monitors, who pulled out of the unarmed mission after the EU classified the Tamil Tigers as "terrorists". Only Norwegian and Icelandic officials remain.

Analysts say a "major international initiative" is needed to prevent a war.

"The Norwegians have proved impotent in the last eight months and what is needed is a powerful international initiative that induces both sides to drop hostilities," said Jehan Perera, an analyst at the independent National Peace Council. "It will take the UN or the US to compel them to stop. Otherwise I do not see a logical end to the violence."