Ahmad Jarrar was killed in the northern West Bank town of Yamoun where he had been hiding, the agency said, describing him as an "active" participant in the January 9 murder of Rabbi Raziel Shevah.
"During the attempted arrest, the terrorist came out of a building where he was hiding armed. Security forces fired in his direction, an M-16 assault rifle and a bag containing explosives were found near his body," the agency said in its statement.
Ahmad Jarrar, the man accused of orchestrating the rabbi's murder, is the son of Nasser Jarrar, a Hamas commander killed by Israeli forces during the second intifada, the mass uprising by Palestinians against Israeli occupation between 2000-2005.
Raziel Shevah, a 35-year-old rabbi, was shot dead near Havat Gilad, the wildcat Jewish settlement outpost he lived in near the West Bank city of Nablus, on January 9.
Israeli forces have been hunting for the assailants since then, with roadblocks and checkpoints set up following the murder.
Two Palestinians have been killed during earlier raids which Israeli security services said were launched to find Shevah's killers.
Israeli settlements are seen as illegal under international law and major obstacles to peace as they are built on land the Palestinians see as part of their future state.
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