Somali government troops and Islamist fighters are massing around the central town of Burhakaba a day after it was taken by government forces.
Islamist militias have taken control of large parts of Somalia
Residents are fleeing as Islamic Courts rebels vow to retake the town - close to the government stronghold of Baidoa.
Ethiopian soldiers are said to have helped the government troops.
With Eritrean soldiers suspected of helping the rebels, diplomats have warned the situation could spiral out of control, engulfing the whole region.
The danger is of a conflict for control of the Horn - a proxy war between Ethiopia and Eritrea, continuing the border war between the two states that ended six years ago in an uneasy peace, says the BBC's Africa analyst Martin Plaut.
Somalia has been in the grip of warlords and militias for years and has not had a functioning national government since 1991.
The Union of Islamic Courts (UIC) has consolidated its control over much of southern Somalia after seizing Mogadishu in June.
But Saturday's fighting is being seen as a challenge to their authority - as well as a prelude to a wider confrontation, says our Africa analyst.
Hundreds of Islamists have now converged on the nearby town of Lego.
"The Ethiopians have attacked Burhakaba and if they don't leave we will attack them," commander Sheikh Yusuf Mohamed Siad told Reuters news agency.
"Ethiopia and its allies are against the peace we have brought to Somalia after 16 years of unrest," he said.
Reuters said battlewagons - lorries mounted with heavy machine guns and anti-aircraft rockets - were moving into Lego.
"If these attacks continue we will ask other Islamic nations to help us," he said.
The transitional government has repeated its denial that it has any Ethiopian troops with it.
Ethiopia denies having troops in Somalia but says it has sent advisers.
But the government has repeatedly denied Ethiopian military support, despite eyewitness reports to the contrary, says our analyst.
Diplomatic sources estimate that between 6,000-8,000 Ethiopians are now inside Somalia, bolstering the government's faltering control.
Ranged against them are not just the well-armed militia of the Islamic Courts, but also about 2,000 fully equipped Eritrean troops, says our analyst.
Both sides in the Somali conflict are reported to have major outside backers - the government supported by Ethiopia, Uganda and Yemen; the Islamic Courts receiving aid from Iran, Libya, Saudi Arabia and Gulf States.
Arms are reported to be flowing into the country on a daily basis, says our Africa analyst.
And the diplomats warn that if the Eritreans, now reported to be on the frontline, come into a direct confrontation with the Ethiopians it could take the whole region down, says our analyst.