"Bullets and heavy rockets are flying everywhere," a Somali driver stranded by the fighting told the Reuters News Service. "Fresh Islamist troops are now fighting Ethiopians who are waiting for backup," he said.
The clashes took place in Daynunay, site of a government base, and in Buur Hakaba, Reuters reported, with Islamist forces arriving from their stronghold in the capital Mogadishu.
The Islamist forces, the military wing of the Somalia Islamic Courts Council, or SICC, have for several weeks threatened holy war against Ethiopian troops, who they say have invaded their country.
Ethiopia, however, claims to be defending the town of Baidoa, the seat of Somalia's interim government, and the only area under government control.
The government has little to no power in the rest of the country which has been run by warlords for much of the past decade. Islamist forces fought the warlords and took over control in June. Since then they have been enforcing Islamic Sharia law in many areas, particularly in the south.
Despite Wednesday's fighting, marked by rockets and heavy weapons and clashes late Tuesday southwest of Baidoa, Somalia's top Islamist leader Sheikh Hassan Dahir Aweys denied the two groups were at war.
"The war has not started," he said. "This is a small incident."
Aweys spoke with reporters following a meeting with European Union envoy Louis Michel, who traveled to Somalia on a diplomatic mission to negotiate peace between the government and the SICC, according to Reuters.
Following the meeting, Michel said both sides had agreed to attend a second round of peace talks in the Sudanese capital of Khartoum, though government officials did not confirm their participation.
Peace negotiations took place in November in Khartoum, but ended without resolution.
Military experts estimate between 15,000 and 20,000 Ethiopian troops are in Somalia backing the government, while Ethiopia's rival Eritrea has about 2,000 troops backing the Islamists, Reuters reported.
Analysts fear fighting in the country could descend into a major regional battle affecting the entire Horn of Africa.