They said heavily-armed government troops attacked the town of Burahakaba, about 60km southeast of Baidoa, sparking clashes with the local militia loyal to al-Bayan Islamic Court movement.
Aljazeera's correspondent reported that government troops have seized the town. Burahakaba is now under the control of the interim Somali government, he said.
"Government troops supported by Ethiopian soldiers attacked us in Burahakaba. I have ordered the local militia to retreat from the town," Sheikh Mohamed Ibrahim Bilal, the regional al-Bayan leader, said.
"We were ambushed in the town. They attacked us and we have been fighting for about an hour. There are casualties but I cannot say how many. My men have been wounded and we have been pushed from the town," added Ibrahim Burow, the commander of the local militia.
Residents said they saw fighters in Ethiopian military uniform fighting alongside government troops in the township.
Early this month, Somali government soldiers backed by Ethiopian forces briefly seized control of the town from the local militia, insisting that it lies in area under control of the weak government.
The seizure prompted the Supreme Islamic Council of Somalia (SICS) to declare a holy war on Ethiopia.
"Both sides exchanged fire. We fear that the clashes might escalate," said Hassan Mukhtar, a resident of the outpost.
Ethiopia backs the Somali transitional government that is increasingly threatened by Islamists who seized Mogadishu in June from warlords after months of fierce fighting and now control most of southern and central Somalia.
Addis Ababa has been accused of sending thousands of troops into Somalia to defend the government from feared Islamist attacks but Prime Minister Meles Zenawi repeated on Thursday that the only Ethiopian soldiers on Somali soil were military trainers.
Somalia has been wracked by chaos and without a functioning central government since the 1991 ouster of strongman Mohamed Siad Barre, who assumed power in 1969. He died in exile in Nigeria in 1995.