Pro-Gaddafi troops have forced the rebels to retreat from Bin Jawad, a town 150 kilometres east of Gaddafi’s hometown of Sirte.
Intense fighting was reported in the town before the anti-Gaddafi rebels fled in their vehicles.
It is the first setback for the rebels since the Allied airstrikes began on March 19.
The Allied airstrikes had allowed the ill-equipped and inexperienced rebels to advance West and seize a number of towns and oil installations, including Ras Lanuf, Brega, Uqayla and Bin Jawad.
The rebels were advancing on Sirte when they were stopped by heavy artillery used by pro-Gaddafi soldiers and forced to retreat.
A Pentagon spokesman Vice Adm Bill Gortney told the BBC that any gains the rebels made would be “tenuous” given their lack of experience and military hardware.
Meanwhile Misrata, a rebel held town close to the capital, Tripoli, is also reportedly facing heavy bombardment from government backed forces.
Eight civilians are believed to have been killed.
“Misrata is in danger,” a rebel spokesman told the AFP news agency.
“The massacre that was avoided in Benghazi thanks to the intervention of coalition forces will be carried out in Misrata.”
The counter-offensive by pro-Gaddafi forces comes as delegates from more than 40 countries gathered in London for a conference aimed at discussing Libya’s future post-Gaddafi.
The dictator has ruled the country with an iron fist for 41 years.
Yesterday US president Barack Obama defended America’s involvement in the airstrikes against Gaddafi’s forces in a televised address to the nation but said that Libyans would need to bring about regime change themselves.
The US had not ruled out arming the rebel forces.
