Civilian militias armed with slingshots, machetes and spears were seen roaming the Villa Verde neighbourhood in southern Dili, throwing rocks through the windows of the small, tin-roofed houses and setting them on fire.
Hundreds of panicked residents sought shelter in churches as Australian soldiers arrived in tanks and Land Rovers to try to restore order.
The number of casualties was not known but ambulances were seen leaving the scene with sirens blaring.
The gangs are apparently allied with police and former soldiers angered by the dismissal in March of 600 soldiers - more than 40% of the country's army - after they went on a monthlong strike to protest poor working conditions.
At least 23 people have been killed in a week of fighting that poses the most serious threat to the desperately poor country since it broke from Indonesian-rule in 1999.
It comes despite the nation receiving millions of dollars in international assistance over the last seven years, much of it focused on building up its army.
Australian soldiers secured the
main airport in the capital Dili
East Timor's government asked for international help earlier this week, saying it could not control the situation, and hundreds of Australian troops have already arrived. New Zealand, Malaysia and Portugal have also agreed to send forces.
Two Australian tanks moved into the Villa Verde neighbourhood early on Saturday as the militias torched homes, sending screaming women and children running into the streets.
Other soldiers arrived in Land Rovers and set up positions along the perimeter.
The dismissed soldiers are largely from the country's west, while the military's leadership originates from the east. The renegade soldiers alleged they were discriminated against, routinely passed up for promotions and given the worst assignments.
After engaging in deadly riots last month, the rebels fled the capital, setting up positions in the surrounding hills and threatening guerrilla warfare if they were not reinstated."