The leader of the Union of Islamic Courts (UIC), which controls much of southern Somalia, says the country is in a state of war with Ethiopia.
"All Somalis should take part in this struggle against Ethiopia," Sheikh Hassan Dahir Aweys said from Mogadishu.
Heavy fighting for a second day is some 20km from the government's Baidoa base. There are fears conflict could plunge the entire Horn of Africa into crisis.
Local residents say Ethiopians troops are clashing with Islamist militias.
See map of flashpoints
Ethiopia denies its forces are battling the advancing Islamists militias.
The two countries have a long history of troubled relations, and Islamists have long called for a holy war against Ethiopian troops in Baidoa.
Both the Islamist and interim government agreed to a ceasefire and to unconditional talks on Wednesday after meetings with a European Union envoy.
But there has been no let up on the ground, with heavy artillery and mortar fire heard in Daynunay, where the government has a military base.
Local media report bodies strewn along streets. Both sides claim to have killed and wounded dozens of fighters.
Somalia's Deputy Defence Minister Salad Ali Jelle told reporters in Baidoa that 71 Islamic fighters had been killed and 221 injured so far during clashes in three locations.
But in Mogadishu, UIC official Sheik Mohamud Ibrahim Suley claimed his fighters had killed 70 fighters, mainly Ethiopian troops.
Neither claim can be independently verified.
After talks in Baidoa, EU envoy Louis Michel travelled on to Mogadishu, where he met UIC leaders.
He then announced both parties had agreed to resume efforts to find a negotiated settlement of their differences.
A nine-point memorandum of understanding included agreement to begin talks again without preconditions, he said.
The UIC set aside a demand that Ethiopian troops withdraw from Somalia as a precondition for talks, Mr Michel added, although it remained a major grievance.
Mr Michel has urged both sides to begin talks as soon as possible, at the latest early in January.
Both sides have blamed each other for the fighting.
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.
Ethiopia has admitted to having some military trainers in Somalia, but our correspondent says that as he drove to the airport in Baidoa on Wednesday, he was stopped by a huge convoy of Ethiopian military armour.
The United Nations estimates as many as 8,000 Ethiopian troops may be in the country backing the government while regional rival Eritrea has deployed some 2,000 troops in support of the Islamic group.
Other countries are thought to have become involved in arming both sides.
Courtesy of: www.bbc.com