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Anti-Gaddafi forces have been forced to pull back from Bani Walid after meeting fierce resistance from those loyal to the ousted Libyan leader.
Fighters came under heavy shelling and gunfire after entering the town, 90 miles (140 kilometres) south-east of the capital Tripoli.
Further to the east, forces are continuing an assault on Sirte, another remaining Gaddafi stronghold.
Earlier, the UN voted to give Libya's seat to the transitional authorities.
The move, which faced only minor opposition, clears the way for National Transitional Council (NTC) chief Mustafa Abdul Jalil to attend the UN General Assembly in New York next week.
US officials say President Barack Obama will meet Mr Jalil on the sidelines of the gathering on Tuesday.
The UN has also passed a resolution to ease sanctions against Libya, including on its national oil company and national bank.
British Foreign Secretary William Hague said about $19bn (£12bn) in Libyan assets frozen in the UK would be gradually released as a result.
Concern for civiliansShortly after entering Bani Walid, NTC forces were were hit by sniper fire, mortar attacks and rocket barrages as they tried to advance on the city centre.
"We have received orders to retreat. We have been hit by many rockets. We will come back later," Assad al-Hamuri, a fighter, told Reuters as forces began their withdrawal.
Forces are now trying to regroup on the outskirts of the city, reports say.
According to Reuters news agency, the streets in the northern outskirts of the town were deserted and houses there were riddled with bullet holes.
The BBC's Ian Pannell, in Tripoli, says the latest attacks suggest the battle for the remaining contested areas of Libya could be entering a decisive phase.
But there is concern for the tens of thousands of civilians still believed to be living in both cities, and who have been surviving for weeks with limited access to food, water and electricity, our correspondent adds.
