By Aleksandar Vasovic and Gleb Garanich
VUHLEHIRSK/KRAMATORSK, Ukraine (Reuters) - Rockets killed civilians and soldiers deep in Ukrainian government-held territory on Tuesday and rebels pushed on with an assault to cut off an army-held rail junction, setbacks that showed Kiev's position worsening on the eve of peace talks.
Advances by pro-Russian rebels diminished hopes of a deal when Russia, Ukraine, France and Germany hold a summit in Minsk on Wednesday under a new Franco-German initiative to halt fighting in a war that has killed more than 5,000 people.
European officials say it is difficult to imagine the rebels agreeing to halt and go back to earlier positions after weeks during which they have been advancing relentlessly.
A Russian source quoted by the state RIA news agency said there were no plans to sign a document to resolve the conflict at the peace talks, and the main subject would be creation of a demilitarized zone.
Rockets crashed into Kramatorsk, some 50 km (30 miles) north of the front, hitting the main headquarters of the Ukrainian military campaign in the east, as well as nearby residential areas. Local officials said at least seven civilians were killed, while 26 civilians and 10 soldiers were wounded. A parliamentary deputy said four soldiers were also killed.
A Reuters photographer saw the body of a woman who had been killed, laid out in light snow where she fell. The tail of a rocket stuck out of a small crater in the ground.
The rebels denied firing on the town, but their apparent ability to strike so far into Ukrainian-held territory will complicate peace talks that aim to reestablish a ceasefire the separatists repudiated with a new offensive since last month.
At the front in Vuhlehirsk, a small town captured by rebels last week, volleys of artillery crashed in both directions. The rebels are pushing to encircle government forces holding out in nearby Debaltseve, a rail hub that is the main rebel target.
Rebels sounded triumphant and said they had no intention of halting while they had government troops on the back foot.
"The Debaltseve bubble has been shut firmly. We will not let them out. There is no way they can get out," said a commander of a reconnaissance unit who identified himself by the nom de guerre of Malysh - "Little One".
Asked about a ceasefire, Malysh, who said he was a Russian fighter and not a Ukrainian, replied: "We are absolutely against it. They will have time to regroup. We have them now."
The Kremlin, which the West accuses of sending arms, weapons and soldiers across the frontier to help fight for territory it calls "New Russia", announced month-long war games on Tuesday involving about 2,000 troops on its side of the border. Russia denies involvement in the fighting in Ukraine.
The renewed fighting has brought calls in the West for more pressure against Moscow. U.S. President Barack Obama is weighing whether to deliver weapons to Kiev.
He met Germany's Chancellor Angela Merkel on Monday but announced no decision on weapons, despite several senior officials in his administration coming out last week in favor of sending some arms. European countries oppose sending arms to Kiev, arguing this would escalate the war while providing nowhere near enough fire power for the Ukrainians to win it.
The war and years of endemic corruption have nearly bankrupted Ukraine, where the currency collapsed last week. Ukraine is negotiating a rescue package with the International Monetary Fund. Sources said that could be expanded dramatically to provide as much as $40 billion in aid.
Kiev announced on Tuesday that its forces had launched a counter-offensive in the southeast to relieve separatist pressure on the coastal town of Mariupol, the biggest city in the rebellious provinces still in government hands.
Details of that counter-offensive could not be confirmed, but it is unlikely to provide much relief at the main battle front where government forces have been steadily pushed back.
At the outskirts of Vuhlehirsk, a rebel reconnaissance unit was busy securing trenches and bunkers that had been abandoned by Ukrainian troops. They scavenged weapons, ammunition, wires for field telephones and even discarded boots, sleeping bags and mats. An armored rebel column of tanks and trucks approached the newly captured town.
In the backyard of an abandoned home, Malysh, the reconnaissance squad commander in a brand new, Russian-style uniform with no insignia?, wiped snow from the face of a dead soldier with a Ukrainian flag shoulder patch.
"Come and see, this is the face of a NATO murderer," Malysh said.
Senya, commander of a Cossack volunteer unit in a traditional fur hat with cockade, said rebels were ready to advance to Ukrainian ?positions about three kilometers away.
"Top commanders are calling this 'the Debaltseve cauldron', and we will squeeze Ukrainians so much it will no longer be a cauldron but a tea cup," he said of the curve in the front line where Ukrainians are surrounded on three sides by rebel forces.
Civilians have suffered on both sides. In the village of Kondrativka, Lyubov Afanasievna, 52, stood in front of her home which was missed by less than five meters by an artillery ?shell that left a three meters-wide crater in front.
About hundred meters away a small house at a road crossing was blown to bits by a direct impact: "It was a miracle, there were people inside and they are all alive," she said.
Dmytro Tymchuk, a military analyst with good sources in the Kiev armed forces, said the rebels near Debaltseve were now trying to cut off the main highway - and the main supply line for government forces - running north at Logvynove.
Military spokesman Andriy Lysenko said on Tuesday that an attack on Logvynove had been pushed back but fighting was ongoing there. He said Russian forces were building up just inside Russia near the joint border.
Seven Ukrainian soldiers had been killed and 23 wounded in the past 24 hours, military spokesman Anatoly Stelmakh said before the rocket strike on Kramatorsk.
(Additional reporting by Pavel Polityuk, Alessandra Prentice, Richard Balmforth and Yekaterina Golubkova; Writing by Peter Graff; Editing by Sophie Walker)