JERUSALEM, Aug 16 (Reuters) - Israel on Friday destroyed the family homes of two Palestinian militants held responsible for the killings of at least 17 Israelis, pursuing a policy meant to deter violence but condemned by human rights groups.

In a statement, the Israeli army said soldiers blew up the home of Iyad Sawalha in the village of R'ai near the West Bank city of Tulkarm because of his hand in planning a bus bombing in June near the northern town of Megiddo that killed 17 people.

Residents of R'ai said 12 people were rendered homeless after troops flattened the two-storey house overnight. Sawalha was in hiding elsewhere, according to the army.

Troops also razed the house of Morad Mohammed Abu Asal in Anabta, also near Tulkarm. The army said Asal carried out a suicide attack in Taibe, an Arab village in northern Israel, in January that wounded two security officials.

Israel recently adopted a policy of blowing up the family homes of militants to try to deter attacks carried out in a 22-month-old Palestinian uprising for independence in the West Bank and Gaza Strip.

Human rights organisations and Palestinians have condemned the policy as collective punishment violating international law.

IRAQ

Amid speculation of a U.S. strike on Iraq and possible Iraqi retaliation directed at Israel, an Israeli newspaper reported on Friday that Prime Minister Ariel Sharon had urged Washington not to delay taking action.

The liberal daily Ha'aretz said Sharon had sent Bush messages in recent days that postponing a strike would "not create a more convenient environment for action in the future", but that Israel, Washington's main regional ally, would support any decision regarding method and timing.

U.S. President George W. Bush has described Iraqi President Saddam Hussein as a "serious enemy", but is facing international opposition to his consideration of military action to topple him.

DEMOLITION DRIVE

Sharon has sought new ways to discourage Palestinian suicide bombings and ambush shootings.

The army says it has destroyed at least 23 homes since last month to send a message to "suicide terrorists and those participating that terror activity has a price that everybody involved in one way or another will pay".

Attacks have tailed off somewhat but the Israeli army still occupies seven West Bank cities it swept into in June after a spate of bombings. The cities were placed under Palestinian rule in interim peace deals in 1994-95.

Demolitions resumed a day after Palestinian officials said Israeli tank fire killed a five-year-old Palestinian boy at the edge of Khan Younis refugee camp in the Gaza Strip.

They said two Palestinian men were wounded when they tried to go to the aid of the boy, Ayman Fares, lying outside his house in the densely populated area. A Palestinian security source said the tank fired "without reason".

An Israeli army spokesman said gunmen had opened fire on Israeli forces, who returned fire and injured one of the men.

The violence dogged hopeful signs of political progress after a senior Palestinian official announced a reform that would help meet U.S. demands for reviving peace talks.

Palestinian Finance Minister Salam Fayyad said a holding company had been formed to consolidate all Palestinian Authority funds and assets under a single umbrella.

The United States has ruled out any Palestinian state until Palestinians weed out corruption, choose leaders "not compromised by terror" and neutralise militants responsible for a campaign of suicide bombings and ambush shootings.

Palestinian President Yasser Arafat has denied supporting militant violence against Israeli civilians. He has pledged democratic reforms but says they will be difficult to realise unless Israeli troops withdraw from West Bank cities.

Israel said after recent meetings with Palestinian officials it would release more tax receipts owed to the Palestinian Authority but frozen after violence erupted in 2000.

But it insists the funds, totalling some two billion shekels ($425 million), not be used to fund "terror activity".

At least 1,503 Palestinians and 588 Israelis have been killed since the uprising began after U.S.-brokered negotiations on creating a Palestinian state stalled. Nampa-Reuters