Smoke has been billowing over Tetovo
A 12-year-old girl was killed and at least 24 civilians and soldiers injured as the two sides exchanged automatic weapon and mortar fire for a second day.
In a separate incident, a Macedonian soldier was killed on the Albanian border in an attack blamed on the rebels.
Western diplomats said the fighting seriously undermined hopes of getting the two sides to resume peace talks, stalled since last week.
'No military solution'
The flare up came a day before President George Bush was due to visit US troops in the province of Kosovo, across Macedonia's northern border.
US State Department spokesman Philip Reeker called for both sides to respect the ceasefire.
"There is no military solution to the problems of Macedonia," he said.
The clashes began in Tetovo on Sunday, although Monday's fighting was more serious.
The two sides fought for control of an area around the town's sports stadium. Rebel fighters also launched mortars at a barracks.
Macedonian Government forces responded by pounding villages in the mountains above the town, seen as a refuge for fighters from the rebel National Liberation Army.
"Today we have real war in Tetovo," a 38-year-old resident told Reuters news agency.
As the fighting continued, scores of cars were seen fleeing in the direction of Skopje, the capital.
Stalled talks
The fighting came as US and European envoys met with President Boris Trajkovski, in the hope of luring Macedonian and Albanian leaders back into making progress in stalled negotiations.
Talks broke down over a draft peace proposal. It suggested retaining Macedonian as the primary official language and keeping central state control over the police, but proposed Albanian as a second official language in some areas - a key demand for rebel leaders.
The language issue was the main sticking point, with many Macedonians opposed to any suggestion that Albanian become an "official" language.
Tetovo is regarded as the unofficial capital of Macedonia's ethnic Albanian minority.
In March the city and its surrounding villages were the scene of a month of fighting between the rebels and government forces.
The Albanian rebels say they are fighting to end discrimination.
The Macedonian authorities argue the rebels are trying to seize territory in order to secede from the country.