By Anuruddha Lokuhapuarachchi

VALACHCHENAI, Sri Lanka, Nov 9 (Reuters) - Thousands of Sri Lankan Tamil refugees fled their camp in rebel territory in the island's east on Thursday, survivors said, a day after the army bombed the location killing dozens of civilians.

As they poured out of the camp, the navy battled Tamil Tiger rebels at sea off the island's northern tip after Tiger suicide boats attacked patrol vessels, officials said.

The rebels said they were attacked while conducting naval exercises, had sunk one military attack craft and that a second was sinking.

They denied suicide boats were involved, but the navy said otherwise.

"They have come in a large number of suicide boats and attacked our vessels," military spokesman Brigadier Prasad Samarasinghe told Reuters. "A sea battle has erupted and is still going on."

The navy said both sides suffered damage, but there were no immediate reports of casualties.

The battle came as rights groups and diplomats voiced outrage at Wednesday's army artillery attack on a refugee camp in the eastern district of Batticaloa as doctors tended infants and elderly among at least 125 civilians with multiple shrapnel wounds.

Many analysts fear a new chapter in a two-decade civil war could escalate after peace talks collapsed in late October.

Palachchenai Kadiraveli, 29, managed to board a fishing boat with her daughter and 20 others before dawn on Thursday, escaping across a lagoon patrolled by navy fast attack boats to government-held territory.

"There were a lot of explosions, so many people dead and wounded," she told Reuters after landing near the town of Valachchenai in government territory in the eastern district of Batticaloa. "A lot of children died.

"I jumped into a bunker with my daughter," she said, clutching two bags containing clothes and a bottle of soda. "My husband stayed behind to protect our belongings. There are thousands of people trying to leave."

REFUGEES FLEE FOR THEIR LIVES

Nordic truce monitors said they had received reports that thousands of people were on the move in the rebel-held area -- where around 35,000 people are camped out after being displaced by fighting which flared further north in August.

Doctors at Valachchenai's basic hospital struggled to cope with 60 wounded early on Thursday, so the patients were moved to the major town of Batticaloa, where some dead and injured had already been taken.

"My son stopped to talk to friends near the refugee camp," said 43-year-old labourer Sellappa Rajendran, weeping outside Batticaloa hospital morgue. "There was a huge explosion, masses of smoke. I saw a lot of dead bodies. One was my son."

The Tigers say 47 people were killed in Wednesday's attack on the camp, set up in a school in the rebel-held village of Kathiraveli. Nordic truce monitors counted 23 corpses, but did not rule out a higher figure.

"Our monitors saw there were no military installations in the camp area, so we would certainly like some answers from the military regarding the nature and reasons of this attack," said Sri Lanka Monitoring Mission spokeswoman Helen Olafsdottir.

The attack came after days of artillery duels between the military and the Liberation Tigers of Tamil Eelam (LTTE) in the island's north and east, where the rebels want to carve out a separate homeland for minority Tamils.

The military accused the Tigers of using civilians as human shields and exaggerating casualties.

"While we regret this whole episode, we also say that national security is utmost and it has to be maintained, and as such defensive action by the authorities is something that is inevitable," said defence spokesman Keheliya Rambukwella.

Peace mediator Norway said it was appalled at what it called a government "onslaught".

Many fear the worst violence since a now-battered 2002 ceasefire could escalate into a return to a war that has killed well over 65,000 people since 1983. (Additional reporting by Simon Gardner and Ranga Sirilal in COLOMBO)

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