Local Islamist leaders said hundreds of heavily armed government fighters and Ethiopian soldiers entered Buur Hakaba on Monday, pushing out fighters loyal to the Supreme Islamic Council of Somalia (SICS), which controls much of the country including the capital Mogadishu.
"Ethiopian forces have taken over Buur Hakaba. My militiamen were forced to retreat to ... Jameah," said Sheikh Mohamed Ibrahim Bilal, a commander from the militia group that had been holding the town.
A government commander has denied that Ethiopian troops were involved.
The move is the first major offensive by the interim government, which holds little power outside its base in Baidoa.
Officials from the SICS said Ethiopian soldiers had also entered the central Hiran region near the town of Beledweyne, which they last week accused Ethiopia of bombing.
Sheikh Abdullahi Gurre, the SICS representative in Beledweyne, speaking to AFP news agency said: "Hundreds of Ethiopian forces have crossed the border which the Islamic courts announced closed and they are now some 25km inside Somali territories."
Over the weekend, Islamic officials announced that they had closed the border with Ethiopia.
"Starting from today, we have declared jihad against Ethiopia."
Sheikh Sharif Ahmed,
Supreme Islamic Council of Somalia
"This is clear aggression," he said. "Our forces will face them soon if they do not retreat from Somali territories".
Ethiopia, which is mainly Christian, has backed Somalia's interim government against the Islamists which it has accused of being "jihadists".
Sheikh Sharif Ahmed, a leader of the SICS in Mogadishu, told a news conference: "Starting from today, we have declared jihad against Ethiopia.
"Somalis in and outside the country are obliged to defend their country and their religion. You should be ready for an order and execute it as you will be told."
Ethiopia has repeatedly denied that its troops have entered Somalia, but made it clear that it would step in to protect the government from the Supreme Islamic Council of Somalia.