Col Muammar Gaddafi announced an imminent assault on Benghazi after world leaders refused all forms of military intervention in Libya.
France and Britain failed to persuade other powers meeting in Paris to impose a no–fly zone over the country, where pro–Gaddafi forces claimed to have taken the last major town before the rebel stronghold.
The no–fly proposal was absent from the G8 foreign ministers' closing statement in Paris, following resistance from Russia, Germany and the US. China, a United Nations security council veto–holder, is also opposed.
Alain Juppé, the French foreign minister said: "If we had used military force last week to neutralise some airstrips and the several dozen planes that they have, perhaps the reversal taking place to the detriment of the opposition wouldn't have happened.
"We have perhaps missed a chance to restore the balance."
Col Gaddafi, in an interview, said Germany, Russia and China would now be rewarded with business deals and oil contracts.
Residents of Ajdabiya in eastern Libya said government soldiers entered its streets before nightfall and quickly encircled the town.
The army announced on state television last night that it was preparing to reclaim Benghazi. "The armed forces are arriving to ensure your security, undo the injustice done to you, protect you, restore calm and bring life back to normal," the statement said. In a television address, Col Gaddafi said "we are determined to crush the enemy".
Rebels who had lost a string of oil towns in the past week had planned to dig in to defend Ajdabiya, which controls the coast road to Benghazi and the desert road to Tobruk and the Egyptian border.
But by early afternoon, fighters were retreating from Ajdabiya amid scenes of panic. Cars crammed with children filled the road to Benghazi as families joined pickups packed with soldiers and trucks fitted with anti–aircraft guns, while the crump of exploding rockets echoed through the streets.
Sherif Layas, 34, a marketing manager before he took up arms and joined Libya's revolution, said that Gaddafi's forces were about to reach the point where the rebels would be unable to resist without outside help. "This is the death line, right here," he said.
G8 members did agree that the UN Security Council should "increase the pressure, including through economic measures, for Muammar Gaddafi to leave", Mr Juppé said. Diplomats are drafting a UN resolution. "There is a common appetite to increase the pressure on the Gaddafi regime," said William Hague, Foreign Secretary.
Insurgents have been desperately calling for a no–fly zone, and the Arab League gave support over the weekend. But Russia said it wanted more details on how it would work, while Germany said it was "very sceptical".
"We do not want to get sucked into a war in North Africa," said Guido Westerwelle, their foreign minister. David Cameron said the Gaddafi regime had already committed "multiple breaches" of an existing UN resolution. The Prime Minister told the Cabinet that Col Gaddafi must be made to comply with orders not to attack civilians, as set out in UN resolution 1970.
Nicolas Sarkozy has called for the toughest action against the regime.
In a last–ditch diplomatic gamble, Britain and France last night formally asked the United Nations to impose a no–fly zone on Libya. Mr Cameron and Mr Sarkozy tabled a draft resolution to the UN Security Council proposing a range of curbs on the regime. Mr Cameron's aides said the UN move had to be attempted before the dictator restored his control of the country.
Col Gaddafi warned that the West would pay for its hostility – except for Germany. "We don't trust their ambassadors any more, they have conspired against us," he said.
"We don't trust their firms. We are going to invest in Russia, India and China now. That's where our money is going to be invested. Oil contracts will now go to Russian, Chinese and Indian firms."