Fighting between Israel and militants in Lebanon escalated over the weekend, raising fears of a possible full-blown war. That comes on top of persistent market anxieties about the West's nuclear standoff with Iran, threats of supply disruptions in Nigeria and the Gulf of Mexico hurricane season.

"Slim spare capacity, continued demand and a spate of geopolitical threats to supply all point toward bullish oil markets and yet more upward pressure on crude," said Simon Wardell at Global Insight.

The plunge in prices came after a German television report that Iran had accepted incentives promoted by Western nations to resolve a dispute over its nuclear program.

Israeli fighter bombers pummeled Lebanese infrastructure Monday, setting Beirut's port ablaze and hitting a Hezbollah stronghold in attacks that killed at least 17 people. Hezbollah retaliated by firing rockets that flew farther into Israel than ever before.

By midday in Europe, light, sweet crude for August delivery was down 78 cents at $76.25 a barrel in electronic trading on the New York Mercantile Exchange. It had earlier traded as high as $77.74 and as low as $75.60.

The contract reached a record of $78.40 a barrel during trading Friday before settling at an all-time closing high of $77.03.

September Brent crude futures on London's ICE Futures exchange fell 89 cents to $76.69 a barrel, after hitting a new high of $78.18 earlier Monday, then dropping to $75.73.

Gasoline futures dropped more than 2 cents to $2.300 a gallon while heating oil prices dropped 2 cents to $2.0543 a gallon. Natural gas prices fell 22 cents to $6.125 per 1,000 cubic feet.

"Oil prices are higher because the conflict between Israel and Lebanon worsened over the weekend, and though that obviously doesn't have any direct impact on physical oil supply, people are having trouble seeing where this all ends," said Tobin Gorey, a commodity strategist with the Commonwealth Bank of Australia in Sydney.

Both Israel and Hezbollah signaled over the weekend that their attacks would only intensify fighting that so far had killed at least 174 in Lebanon and 23 in Israel.

British Prime Minister Tony Blair and U.N. Secretary-General Kofi Annan called Monday for the deployment of international forces to stop the bombardment of Israel from southern Lebanon.

Their comments came a day after world leaders forged a unified response at their G-8 summit to the crisis in the Middle East, blaming Hezbollah and Hamas for the escalating violence and recognizing Israel's right to defend itself although they called on the Jewish state to show restraint.