Residents said Ethiopian troops arrived on Thursday afternoon and set up a camp near the president's home there.
A spokesman for the transitional federal government denied that any Ethiopian soliders were in the town and maintained the claims were part of an Islamist plot to launch an attack.
"It is absolutely false," Abdirahman Nur Mohamed Dinari told AFP news agency. "Every time the Islamists want to attack, they start propagating rumours and manufacturing lies."
A top Islamic leader Sheikh Sharif Sheikh Ahmed responded to the reports saying: "We will declare jihad if the Ethiopian government refuses to withdraw their troops from Somalia."
Berhan Hailu, the Ethiopian minister of information, told Reuters in Addis Ababa on Wednesday: "We will use all means at our disposal to crush the Islamist group if they attempt to attack Baidoa, the seat of the transitional federal government."
Forces from the Supreme Council of the Islamic Courts moved to a town near Baidoa on Wednesday, causing fears of further conflict.
Later on Thursday, Francois Fall, the United Nation's special representative to Somalia, urged the transitional government and the Islamists to restrain their respective forces and resume the dialogue they started in Khartoum last month.
Fall said: "I appeal to both sides to respect the ceasefire and other provisions of the Khartoum agreement, including their commitment to refrain from any provocations that could lead to an escalation of the situation.
"The place to deal with differences is at the negotiating table."
Fall said the two sides had made a good start to negotiations when they met in Sudan last month.
He said: "A continuation of the Khartoum process will give them a further opportunity to flesh out their expectations and move towards a peaceful solution."
On Tuesday, the Islamists advanced as far as Buurhakana, about 40km east of Baidoa, which they said they had entered to collect defecting government soldiers.
However, they withdrew from the town on Thursday.
"Ethiopia is closely monitoring the jihadist Islamist group which has now returned to Mogadishu after a warning from Ethiopia not to attack Baidoa, the seat of the transitional government," Hailu said.
The United States has urged Ethiopia to exercise restraint and said the European Union, the US, the African Union, the Arab League and others in an international contact group on Somalia will meet soon to consider the situation.
Somalia invaded Ethiopia in 1978 in an attempt to take land occupied by ethnic Somalis. Ethiopia has since attempted to influence Somali politics to prevent another invasion.
Ethiopia sent troops into Somalia in 1993 and 1996 to crush Islamic fighters attempting to establish a religious government.
Somali President Abdullahi Yusuf Ahmed is allied with Ethiopia and has asked for its support.
Hundreds of Ethiopian troops have been spotted along the countries' border in recent weeks prompting criticism from the Islamists.
Relations between the government and Islamists have been tense since the Islamic courts took control of Mogadishu last month, challenging the authority of the largely powerless government.
The two sides agreed a truce and mutual recognition deal in Sudan on June 22 – the government says the Islamists have broken the deal.
They were due to hold further Arab League-sponsored talks in Khartoum last weekend, but the government boycotted them. On Monday, officials changed their minds and the talks were rescheduled for this Saturday.
Somalia has been without effective central government since clan-based regional commanders overthrew the president, Mohamed Siad Barre, in 1991 and then turned on each other.