Troops set up roadblocks and were searching the area around the settlement of Itamar, near the Palestinian city of Nablus, for the attacker who snuck into the house and killed a couple and three of their children, including a baby.
"This is the despicable murder of an entire, innocent family, parents and their young ones while they slept in their house,"Prime Minister Benjamin Netanyahu said in a statement.
"Israel will not ignore such a contemptible murder and will act aggressively to ensure the security of its civilians and to punish the murderers," Netanyahu said. He called on the Palestinian Authority to assist in catching those responsible.
Salam Fayyad, prime minister of the West Bank-based Palestinian government, said such violence was never justified.
"There should be no doubt over our position regarding violence. We have rejected it totally and we have always condemned it," Fayyad was quoted as saying by the official Palestinian WAFA news agency.
Though no group claimed initial responsibility for the violence, the Islamist movementHamas in control of the Gaza Strip said it offered its "full support" to any actions taken against Israeli settlers.
Israelis responded with horror to the attack on Saturday, the Jewish Sabbath, and it will likely complicate efforts to restart Israeli-Palestinian peace talks, which are frozen over the issue of Jewish settlement building.
Kabha Ma'awiyeh, one of the first paramedics to arrive on scene, said the family members were stabbed in bed and pools of blood had collected on the floor.
Violence in the occupied West Bank has dropped significantly since it peaked during a Palestinian uprising that erupted about a decade ago.
Though tensions in the area had risen earlier in the week when Israeli troops fired live rounds at Palestinians after they clashed with settlers. Ten Palestinians and one Israeli were wounded in the confrontation.
Israel has been loosening restrictions on the movement of Palestinians and goods in the occupied territory but maintains a system of roadblocks and checkpoints.
The army has also limited the scope of its raids against suspected militants in Palestinian towns and villages in favor of Palestinian security forces.
Israeli officials have said Netanyahu, who insists on keeping an Israeli military presence along the West Bank's eastern border in any peace deal, is weighing fresh steps to move the diplomatic process forward.
Israeli media have reported his moves could include a proposal for a Palestinian state along temporary borders, an option Palestinian leaders have already rejected.
According to the settlers' YESHA council, about 100 families live in Itamar.
There was a similar attack on the religious settlement in 2002, when a gunman broke into a house and opened fire, killing four members of one family and a neighbor.
(Reporting by Nidal al-Mughrabi, Ali Sawafta and Ari Rabinovitch, Writing by Ari Rabinovitch; Editing by Jon Boyle)
Creative Commons image via Flickr user Filippo Tafi