The sea battle comes amid a flurry of violence in recent weeks that has killed hundreds as the military tries to capture rebel bases in the east. The Tamil Tigers have hit back with bomb attacks and a daring air raid on an air force base outside the capital, Colombo.
A human rights watchdog said Friday international monitors were urgently needed in Sri Lanka to protect civilians, often deliberately targeted by both sides of the conflict.
The military said its patrol craft spotted five rebel boats, believed to be on a suicide mission, off Kalpitiya, 140 kilometers (90 miles) northwest of Colombo.
They intercepted them and opened fire hitting one boat, which exploded, said navy spokesman Cmdr. D.K.P. Dassanayake.
At least two rebels were on board when it sank, Dassanayake said, adding one navy sailor was wounded by the explosion.
However, the rebels said their forces sank a Sri Lankan ship, killing seven sailors before returning to base without a loss.
"There was a 15-minute battle and one Sri Lankan patrol craft sank and three fled taking aboard the dead and the wounded," said rebel spokesman Rasiah Ilanthirayan from Kilinochchi, the Tamil Tiger's de-facto capital in the north.
"All our craft returned to base safe," he said.
Dassanayake called the rebel version of events "totally wrong."
It was not immediately possible to explain the discrepancies, but both sides frequently deny their own losses and inflate those of the other side.
The Tamil Tigers, who pioneered suicide bombings, have used suicide boats in the past to ram and sink naval vessels and attack Sri Lankan ports.
Also Friday, the army said it discovered a powerful bomb in Jaffna, the northern bastion of the Tamil rebels.
Meanwhile, the London-based Amnesty International group called on the government to allow international human rights monitors into the country.
"Amnesty International is gravely concerned about the rising number of civilians being killed or injured as a result of deliberate attacks in Sri Lanka's increasing violence," the group said in a statement.
"Both sides to the conflict systematically violate their obligations under international humanitarian law to protect from harm those taking no active part in hostilities," the group said, adding that killings, abductions and arbitrary detention of civilians were "daily occurrences."
Amnesty said these violations could only be prevented if there were impartial human rights monitors on the ground in conflict areas, who could document and investigate abuses to identify those behind them and bring them to justice.
Government officials declined to comment on Amnesty's call. The government has in the past rejected requests for monitors, saying they would be interfering in Sri Lanka's internal affairs.
The Tamil Tigers rebels have fought the government since 1983 to create an independent homeland in the country's north and east for the country's 3.1 million minority ethnic Tamils, who have faced decades of discrimination by the majority Sinhalese. The civil war killed at least 65,000 people before a Norwegian-brokered cease-fire in 2002.
The cease-fire temporarily halted the fighting, but more than 4,000 people have died since late 2005, when violence flared again. Both sides still claim to be abiding by the truce.