BAIDOA, Somalia, Dec 21 (Reuters) - Somali Islamists and Ethiopian-backed government forces shelled each other for a third day on Thursday, a day after a European Union envoy said the two sides had agreed to new peace talks.

Three days of fighting with rockets, artillery and machineguns have increased fears of a devastating Horn of Africa war, though hardline Islamist leader Sheikh Hassan Dahir Aweys on Wednesday dubbed the exchanges of fire "a small incident."

The fighting is the most sustained combat so far for control of the anarchic nation, and follows two months of increasingly violent skirmishes along a front line snaking across Somalia.

Thursday's shelling follows shuttle diplomacy by EU aid chief Louis Michel, who visited the two sides' leaders in Baidoa and Mogadishu on Wednesday and said they had agreed to stop fighting and resume peace talks.

Government Deputy Defence Minister Salad Ali Jelle said the new clash erupted in the morning near Dinsoor, 100 km (62 miles) southwest of the surrounded government stronghold, Baidoa.

Dinsoor store owner Dayow Hassan told Reuters the artillery fire appeared to be moving south, away from Baidoa.

"I'm hearing heavy artillery shelling, and it sounds like it's coming closer and closer to us," he said by telephone.

Islamist deputy spokesman Sheikh Ibrahim Shukri had no comment on the shelling but blamed Addis Ababa for the conflict.

"This is a war the Ethiopians started," he told a news conference in Mogadishu.

A Reuters witness saw a dozen trucks load more than 100 troops in Mogadishu and head down the road towards the front.

PEACE UNRAVELS?

Troops of the Somali Islamic Courts Council (SICC), which controls most of southern Somalia by military might and the strict use of sharia law, and the fragile, Western-backed government have been fighting near Baidoa since late on Tuesday.

No independent casualty figures were available and the two sides gave wildly differing counts.

The government's Jelle said "hundreds" of Islamists were killed but gave no figure and did not mention government losses.

Shukri said the Islamists had killed "70 plus, mostly Ethiopians" and had lost only seven dead and 22 wounded in Wednesday's fighting. Ethiopia had no immediate comment.

The fighting appeared to undercut Michel's effort to restart Arab League-mediated talks that failed in November when the SICC refused to talk while Ethiopian troops remained in Somalia.

The SICC gave the Ethiopians -- against whom they have declared holy war -- until Tuesday to leave Somalia, and the fighting began late that evening.

Michel said the SICC had dropped that demand, but diplomats said it was too early to say if this deal would go the way of earlier ones -- agreed verbally but then ignored.

Many fear the struggle to control the strategic nation will descend into all-out war and suck in regional rivals Ethiopia and Eritrea, backing the government and Islamists respectively.

A U.N. report says they and at least eight other nations are pouring weapons and military supplies into Somalia, which has had no central government since warlords overthrew dictator Mohamed Siad Barre in 1991.

Military experts say Ethiopia has sent 15,000-20,000 troops into Somalia, while Eritrea has sent about 2,000.

Addis Ababa says it has sent only a few hundred military trainers. Witnesses have told Reuters the Ethiopians were heavily involved in the latest clashes. (Additional reporting by Bryson Hull in Nairobi and Sahal Abdulle in Mogadishu)

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