A column of Ethiopian trucks, more than 100-strong and including armoured cars, have crossed into neighbouring Somalia.
The Islamists control much of southern Somalia
A BBC reporter has seen Ethiopian troops in uniform in Baidoa, the base of the weak interim government.
Ethiopia denies sending troops into the town, but warned it would crush Islamists who had moved to within 60km.
The Union of Islamic Courts (UIC), which control much of southern Somalia, say they never intended to attack Baidoa and have pulled troops back.
At a press conference in the capital, Mogadishu, one of the UIC leaders, Sheikh Sharif Sheikh Ahmed, called on Ethiopian troops to leave, otherwise, he said, appropriate action would be taken.
But he emphasised that the UIC was not intending to attack Baidoa or Ethiopia as it had nothing to gain from doing so.
Ethiopian government adviser and spokesman Bereket Simon told the BBC that they were closely watching the situation but denied troops had gone into Baidoa.
The BBC's Yusuf Hassan Mursal in Baidoa says 25 vehicles including lorries carrying soldiers and armed pick-up trucks known as technicals entered the town on Thursday morning.
He says their arrival has calmed tensions in the town as residents feared an attack from the Islamist fighters.
The column of military vehicles was reported to have crossed over into Somalia overnight and Ethiopian troops have also stationed themselves in the town of Luk in Gedo region, he says.
"We have seen Ethiopian soldiers in a convoy," Baidoa resident Shukri Abdirahman told AFP news agency.
"This is the first time that Ethiopian troops have been openly seen in Baidoa," another resident said. Witnesses say they are now in a government compound.
Ethiopia's Information Minister Berhan Hailu told Reuters news agency in Addis Ababa that they would use "all means at our disposal to crush the Islamist group if they attempt to attack Baidoa".
Mr Bereket told the BBC's Focus on Africa programme that "Ethiopia is in a position to defend itself to ensure the stability of the Horn of Africa".
"If the Islamic courts led by the Jihadists are attacking Baidoa, we have told them we will not let them do it.
"So far the Ethiopian government has not sent any troops," he said.
The Islamists insist that an attack on Baidoa was never planned and have withdrawn their militia from Burhakaba, where they had advanced on Wednesday.
Mr Ahmed said that the UIC would not have sent a delegation in the Sudanese capital, Khartoum - where they have been waiting for almost a week for peace talks with the government - if this had been the case.
BBC African analyst Martin Plaut says the Ethiopian action puts the future of the transitional government in question.
Far from buttressing the administration, it may be the final blow to its credibility. Many MPs will not wish to serve in what will be seen as a puppet government, and observers believe they may leave Baidoa, he says.
Ethiopia has been a long-term ally of President Abdullahi Yusuf and in the 1990s helped him defeat an Islamist militia led by one of the UIC's leaders, Sheikh Hassan Dahir Aweys.
On Wednesday, Somalia's interim Prime Minister Ali Mohamed Ghedi warned that the Islamists planned to advance on Baidoa, where a curfew has been imposed.
His comments followed reports that 150 government troops had defected to the UIC.
The UIC, which has brought some form of law and order to areas under their control after years of anarchy, has begun a massive clean-up campaign in the capital.
It is the first time rubbish collectors will have access to the whole city, which until last month was split up into fiefdoms controlled by rival warlords.
Correspondents say Mogadishu's litter-strewn streets have been a visible sign that the city has had no central authority for more than a decade.
Hundreds of volunteers joined in to collect the debris on Thursday morning.