Colonel Abdirizak Issak Bihi supports the Transitional National Government in Mogadishu and was ousted from the town of Bulo Hawo on Wednesday.
Somalia has been without a central government since 1991 and the TNG only controls parts of the capital, Mogadishu.
It accuses Ethiopia of trying to keep Somalia weak and divided.
'Scapegoat'
"This is completely untrue. There are no Ethiopian troops in Somalia," Yemane Kidane, of the Ethiopian Foreign Ministry, told the BBC.
"Every time the TNG faces a serious problem, they make up stories like this and use Ethiopia as a scapegoat for their own failures to control their country," he said.
The TNG's information minister had said that Colonel Bihi had been killed.
"We heard that he is still alive safe and sound in the hands of the Ethiopian troops in [the Ethiopian town of] Sufka," a female relative told the BBC's Hassan Barise in Mogadishu.
A spokesman for one of the factions which has taken control of Bulo Hawo also said that Colonel Bihi was still alive.
"He is not killed but the man is a prisoner of our faction and he would face charges related to his misdeeds," Colonel Mohamed Ahmed Ali, of the Somali National Front (SNF) said in Nairobi.
"I talked to his guards Thursday afternoon, he is a prisoner," Colonel Ali told the French news agency, AFP.
Aid arrives
Eyewitnesses who fled across the border to Kenya said that at least two people had been killed and four injured when Ethiopian soldiers attacked Bulo Hawo.
Meanwhile the United Nations refugee agency, the UNHCR, said it was delivering food and assistance to the thousands of Somali refugees who have fled to the Kenyan border town of Mandera.
A planeload of medicines arrived at the district hospital on Thursday.
On Friday, food, water tanks, tents and vehicles are to be sent to the town.
But the Kenyan Government would like the Somali refugees to go home.
It says they are not safe in Mandera, near the border - three were injured by stray bullets during Wednesday's attack.
Ethiopian 'interference'
The government hopes many refugees will return to Bulo Hawo now that it is once again under the control of the Somali Reconstruction and Restoration Council, a coalition of opposition warlords - including the SNF - backed by Ethiopia.
For those who wish to stay, it is considering setting up more permanent camps away from the border.
On Wednesday evening, calm had returned in Bulo Hawo.
But according to the BBC's Hassan Barise, the town is isolated from the rest of Somalia as all its telephone lines and VHF radio went dead after the attack.
An old man who fled Bulo Hawo, but returned to the town briefly, told our correspondent that the city looked like a ghost town with almost no life in it.
"You can only see those armed militias of the SRRC," he said.
The man, who did not want to be named, said he also saw seven houses destroyed by fire and several others by the shelling.
"I have also seen several food stores and shops with their doors wide open," the old man said, "after they were looted during the fighting."