At least 13 people have died in a clash between Somalis and Ethiopian forces who had crossed the border, village elders told the BBC.
They said three Ethiopian soldiers and at least 10 residents of Buhoodle were killed in a checkpoint shoot-out.
Buhoodle is in an area claimed by the semi-autonomous region of Somaliland, which is generally seen as more stable than other parts of Somalia.
Correspondents say Ethiopia and Somaliland are close allies.
They often work together, with Ethiopia assisting with security and Somaliland allowing its neighbour use of the strategic Berbera port.
Ethiopia troops regularly cross into southern and central Somalia and fight Islamists controlling their towns, Reuters news agency reports.
The conflict broke out after villagers expressed anger when soldiers searched several trucks and held them for several days, according to the elders and a district official.
"The Ethiopian forces seized some public transports vehicles from the city. Many people were angered and they clashed with the Ethiopian troops, stirring heavy fighting," Buhoodle commissioner Osman Yousef Mohamed told AFP news agency.
The forces had crossed from neighbouring Ethiopia into Somaliland - a self-declared republic - two weeks earlier.
Residents in the disputed town said that more Ethiopian troops moved in following the confrontation.
"There is so much violence. We can still hear guns firing," resident Safia Yusuf told Reuters.
"A lot of people are fleeing and we are scared the clashes will continue because the Ethiopians haven't left and militias are getting reinforcements," she added.
Somaliland declared independence after the overthrow of Somali military ruler Siad Barre in 1991. Its independence has not been internationally recognised.