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| French Fighter Jet |
French Defence Minister Jean-Yves Le Drian said Diabaly, 400km (250 miles) from the capital, Bamako, was taken in a counter-attack on Monday.
Mr Le Drian insisted France's campaign was "developing favourably".
He said Islamists had retreated in the east but admitted French forces were facing a "difficult" situation against well-armed rebels in western areas.
France has called a meeting of the UN Security Council for Monday.
France began its military intervention last Friday in an attempt to halt the advance of Islamist rebels towards Bamako from bases in the north and east.
Separately, Mr Le Drian said he feared militants in Somalia were planning to stage a "macabre" display of the bodies of two French soldiers killed during a failed attempt to rescue a French hostage.
Friday's raid came hours after the French intervention in Mali.
'Matter of weeks'
Rebels began their counter-attack in Diabaly on Sunday night.
Mr Le Drian told BFM television: "They took Diabaly after fierce fighting and resistance from the Malian army that was not able to hold them off at that moment."
One resident told Reuters news agency: "[The militants] started to infiltrate the town last night by crossing the river in little groups."
A Malian military source told AFP that rebels had come from the Mauritanian border area after being attacked by French planes.
France intensified its air strikes on rebel targets over the weekend, with its aircraft also bombing the town of Gao in eastern Mali.
Mr Le Drian said: "The developments are in line with our expectations. In the east of Mali the advance of the rebels has been blocked. The town of Konna has been abandoned. The terrorist groups are in effect in retreat."
He said the strikes on Gao had caused rebels to flee east.
But Mr Le Drian added: "There is a difficult situation in the west, where we have encountered heavily armed militants. Operations against them are going on as we speak, alongside the Malian army."
Rebels of the al-Qaeda-linked Movement for Oneness and Jihad in West Africa (Mujao), said that France would pay for its intervention.
Another spokesman, Oumar Ould Hamaha, told Europe 1 radio: "France has opened the gates of hell for all the French. She has fallen into a trap which is much more dangerous than Iraq, Afghanistan or Somalia."
At least 11 Malian soldiers and a French helicopter pilot have died since Friday. More than 100 militants are reported to have been killed.
French Foreign Minister Laurent Fabius said France's involvement would last "a matter of weeks" and rejected any parallel with the protracted Western mission in Afghanistan.
"Later on, we can come as back-up, but we have no intention of staying forever," he said.
France has sent about 550 troops to the central town of Mopti and to Bamako.
They are set to be joined by troops from the neighbouring African states of Niger, Burkina Faso, Nigeria and Togo, some of which are now expected to arrive in Mali within days.
Islamist groups and secular Tuareg rebels took advantage of chaos following a military coup to seize northern Mali in April 2012.
But the Islamists soon took control of the region's major towns, sidelining the Tuaregs.
One Islamist group, Ansar Dine, began pushing further south last week, seizing Konna.
The town has since been recaptured by Malian troops with French aerial support.
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