Forces loyal to Libyan leader Colonel Muammar Gaddafi have full control of the key western front line town of Zlitan, Libyan officials say.
They had launched a counter-offensive on Wednesday against advancing rebels, who have been fighting government forces with Nato's support since March.
Libyan officials also said three civilians were killed in a Nato air strike on the outskirts of Zlitan.
Nato said it was investigating the accusation.
A Nato official said a target in the Zlitan area had been struck at 06:30 local time (04:30 GMT) on Thursday morning.
"We are aware of allegations of civilian casualties and we always take such allegations seriously," a Nato statement said.
Coalition forces began operations in Libya under a UN mandate authorising military action for the protection of civilians.
Over recent weeks, the rebels have been slowly advancing on Zlitan from the port city of Misrata, 70km (45 miles) to the east.
From Zlitan, their intention is to advance about 160km (100 miles) along the road to Tripoli.
Bodies in coffins
The BBC's James Reynolds was taken on an official tour of Zlitan by government officials with other foreign journalists on Thursday.
They were driven two hours from the capital, Tripoli, to the outskirts of the town of Zlitan and first shown a house that had been destroyed.
Local residents said three people had been killed early on Thursday morning in a Nato air strike.
Afterwards they were then taken to a local mosque to see three bodies in coffins.
Local people said that the coffins contained the bodies of a woman and her two children - aged five and three.
The journalists were then invited to watch the bodies being buried in the cemetery outside.
Afterwards, the government drove them into the town of Zlitan, where they saw very little activity on the streets.
Our correspondent says this may be because during the holy Muslim month of Ramadan people who are fasting remain indoors.
He said on the 10-minute drive through the centre of town, he spotted no sign of the rebels.
Libyan rebels began an uprising against Col Gaddafi in February - and despite Nato's intervention, they have struggled to break a military deadlock.