Ethiopia says it has repelled Islamist militia threatening the seat of Somalia's transitional government in the town of Baidoa.
Aid agencies say all sides must protect civilians
PM Meles Zenawi said he hoped to pull out his 3-4,000 troops within a week, following days of heavy fighting.
However, the Union of Islamic Courts (UIC) says it has made a strategic withdrawal from frontlines.
A UN envoy to Somalia has urged the Security Council to call for a halt to fighting, or risk a broader conflict.
A failure to reach a political settlement "would be disastrous for the long-suffering people of Somalia and could also have serious consequences for the entire region," Francois Lonseny Fall told the 15-nation council in New York.
However, splits have emerged on the council with Qatar insisting that any statement should call for the immediate withdrawal of all foreign forces, including Ethiopia's, from Somalia.
Other council members say that this should not apply to Ethiopian troops, arguing that they are in Somalia at the request of the interim government.
The Security Council is due to resume its discussions later on Wednesday.
Meanwhile, on the ground, the Red Cross says it is treating more than 600 civilians and combatants injured during the fighting.
It has called on all sides to respect the rights of the injured and prisoners.
'Out of the game'
Mr Meles told journalists Baidoa was no longer under threat.
Ethiopia had already completed half its mission, he claimed - saying many UIC members were "out of the game".
He claimed as many as 1,000 people had died and 3,000 were wounded.
Mr Meles said his forces had found evidence that people from Eritrea and Britain were fighting alongside the UIC militia.
On Sunday, Ethiopia admitted for the first time its troops were fighting in the country, saying it was forced to defend its sovereignty against "terrorists" and anti-Ethiopians.
The UN estimates at least 8,000 Ethiopian troops may be supporting the transitional government.
Earlier on Tuesday, the African Union (AU) said Ethiopia had the right to intervene militarily in Somalia as it felt threatened by the Islamic militia operating there.
An AU official also acknowledged the body had failed to "react properly and adequately" to the Somali situation.
Ethiopian jets fired at Islamist positions for a third day on Tuesday.
The town of Burhakaba, one of the Islamists' main bases, is reported to have fallen to forces loyal to Somalia's interim government.
In recent days, the area around the town - which is close to Baidoa - has been the focus of heavy fighting involving tanks and artillery.
Speaking from Burhakaba, the Somali deputy defence minister, Salad Ali Jele, told the BBC the government aimed to extend its control across the whole country.
"The people [in Mogadishu] are already expecting us," he said.
"We call on the Islamic Courts to surrender... Mogadishu is the capital. It is our duty to go there."
But the Union of Islamic Courts described its reported pullout from areas in central and southern Somalia as a change of tactics.
A leading UIC official, Sheikh Sharif Sheikh Ahmed, told reporters in Mogadishu that the retreat merely signalled a new phase in the war.
"Since Ethiopia started using air power and heavy artillery, we have changed our tactics and are getting ready for a long war," he said.
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