MOGADISHU, march 11 (Reuters) -- Fighting between Somali government forces and al Shabaab rebels in the north of Mogadishu on Wednesday killed 17 people and wounded 65, a Somali human rights group and rescue services said.

Residents said al Shabaab also beheaded two employees of a telecommunications company in the capital who had been accused by the al Qaeda-linked insurgents of spying for the government.

Somali insurgents have fought the government since the start of 2007 and the Western-backed administration has been hemmed into a few blocks of the capital since a rebel offensive last May.

The government has said for several months it will launch a major offensive but has yet to carry out the plan. Rebels have stepped up attacks in various parts of the city in recent weeks and government forces have responded with shelling.

"We have collected 17 dead civilians and 65 others wounded- we took them to various hospitals," Ali Muse, the coordinator of ambulance services, told Reuters.

"Most of the casualties took place this afternoon when fighting became more fierce. The death toll may rise for most people were seriously wounded by shells. Some are likely to die in hospitals."

Somalia's state minister for defence said it was a victory to overpower al Shabaab fighters.

"We have surrounded al Shabaab and driven them away. It was a victory for us and we shall disclose the details tomorrow," Sheikh Yusuf Mohamed Siyad 'Indha Ade', told reporters.

Siyad said some al Shabaab fighters had surrendered while they had captured others.

The beheaded telecoms company staff had been accused by al Shabaab of helping to direct government shells towards rebel positions in Mogadishu, residents said.

"We could see the two beheaded bodies lying on the street but we were afraid to carry them away," said resident Abdullahi Karshe.

Somalia has had no effective government for 19 years and Western nations and neighbours say the anarchic country is used as a shelter by militants intent on launching attacks in east Africa and further afield.

The chaos onshore has allowed pirate gangs to flourish and make millions of dollars from hijacking ships in the Gulf of Aden and the Indian Ocean.

Residents said the fighting escalated in the afternoon after African Union tanks joined in. Government officials would not comment that AU forces were fighting alongside them.

"AU tanks joined later, forcing al Shabaab to pull back carrying dead bodies and injured ones in their cars," resident Ali Samatar told Reuters.

Residents said government troops dragged away the corpse of an al Shabaab fighter believed to be that of a foreigner.

"I could see a government's battle wagon pulling a dead body. I cannot exactly say the nationality of the dead al Shabaab, but he looked like an Arab - the body was white," resident Bare Farah told Reuters.