According to US intelligence reports (G-2), the Japanese leaders were fully aware of their desperate situation but would continue to fight in the hope of avoiding complete defeat by securing a better bargaining position. Allied war-weariness and disunity,or some miracle, they hoped,would offer them a way out. "The Japanese believe,"declared an intelligence estimate of 30 June 1945 "that unconditional surrender would be the equivalent of national extinction,and there are as yet no indications that they are ready to accept such terms."
It appeared also to the intelligence experts that Japan might surrender at any time "depending upon the conditions of surrender" the Allies might offer. Clearly these conditions,to have any chance of acceptance,would have to include retention of the imperial system.
(From G-2 Memorandum prepared for OPD and quoted in Cline, Washington Command Post and Karl T. Compton in an article entitled "If the Atomic Bomb Had Not Been Dropped," Atlantic Monthly (December, 1946))
It is also worth remembering that an invasion of the Japanese Islands was not favoured by all US Commanders. Admirals Leahy and King were strongly opposed to the plan. Trumann eventually supported a compromise based on the invasion plans as proposed by Marshall and MacArthur. The invasion of Kyushu would go ahead on 1 November 1945 and preparations for the Honshu assault would continue, but no final decision would be made until preparations had reached the point "beyond which there would not be opportunity for a free choice." (McCloy, "Challenge to American Foreign Policy")
That's why the Japanese carried on fighting.
Cheers
Steve