Heavy fighting has broken out close to the base of the weak Somali interim government in Baidoa.
The Islamists have called for all Somalis to fight Ethiopia
A deadline from Islamists for Ethiopia to withdraw troops from Somalia or face "major attacks" expired on Tuesday.
Residents say pro-government forces and the Islamic militia exchanged mortar fire at Daynunay, 20km from Baidoa.
Both sides promised a visiting European Union envoy they would resume talks, but there are fears the conflict will plunge the entire region into crisis.
On a last ditch peace mission, the EU's development commissioner, Louis Michel, met government officals in Baidoa before travelling on to the capital, Mogadishu, and holding talks with Union of Islamic Court (UIC) leaders.
He told the BBC that they were faced with a very serious problem.
"Everybody knows that we are not very far from an open, violent conflict with... war," he said.
Both sides blamed each other for the fighting.
Islamic commander Sheikh Mohamed Ibrahim Bilal told AFP news agency: "I can confirm to you that heavy fighting has already started around several front line areas."
Government commander Ibrahim Batari accused the Islamists of mounting the attack. "There is shelling everywhere... our forces are facing Islamists, hell is going on," he said.
"I can hear sounds of bullets, rockets from the side where the defence lines of the Islamic courts and the government are," a resident in the government's military base in Daynunay, southeast of Baidoa, told Reuters news agency.
Islamist spokesman Abdirahin Ali Mudey says the base is now in UIC hands, which residents talking to the BBC confirm.
Meanwhile, clashes have broken out in Moode Moode - a village off the Daynunay-Burhakaba road.
"Islamic militias have attacked us and the fighting is continuing," the government's deputy defence minister, Salad Ali Jelle, told Associated Press news agency about the Moode Moode fighting.
There is also heavy fighting and at least one death being reported near Idale, some 60km (37 miles) south Baidoa, after skirmishes on Tuesday evening.
"Last evening, a reconnaissance team from the government and the Islamic courts clashed [in Idale]," Mr Jelle told Reuters on Wednesday.
"But this morning, ground troops from both sides exchanged mortars from a distance."
In Baidoa, Mr Michel spoke to senior government figures pressing the need for negotiations to start between the two sides.
The Islamists have refused to negotiate with the transitional government until Ethiopian troops leave Somalia.
Ethiopian Information Minister Birhan Hailu told the BBC on Tuesday that his country was always ready for dialogue, but said the Islamists were not willing to talk with the transitional government.
"We don't have troops in Somalia, but as we have said so many times, we have a limited number of military advisers to support the Transitional Federal Government of Somalia.
Louis Michel is pressing both sides to negotiate
But the BBC's Adam Mynott says that as he drove to the airport in Baidoa, he was stopped by a huge convoy of Ethiopian military armour.
There were about 10 large artillery cannons, several vehicles - clearly marked with Ethiopian insignia - loaded with ammunition and many hundreds of soldiers.
He was detained for about an hour by Ethiopian soldiers who appeared on edge and very nervous. Mr Michel's car was not stopped.
The UIC has introduced law and order to the capital and much of southern Somalia for the first time in 15 years and denies links to al-Qaeda.