A column of Ethiopian trucks, more than 100-strong and including armoured cars, is reported to have crossed into neighbouring Somalia.
A BBC reporter has seen Ethiopian troops in uniform in Baidoa, the base of the weak interim government.
Ethiopia had warned it would crush the Islamists who had advanced to within 60km of Baidoa on Wednesday.
But the Union of Islamic Courts (UIC) say they never intended to attack Baidoa and have pulled troops back.
The UIC have rapidly expanded their control of southern Somalia since they took control of the capital, Mogadishu, but observers fear it is only a matter of time before the two sides clash.
"We have no such military plan as claimed by the non-functioning government," the UIC's security head Sheikh Yusuf Mohamed Siad told the AFP news agency.
"The prime minister's claims are a ploy to attract Ethiopian intervention."