Paul Toohey – Saturday morning, things went crazy. The Australians had landed but, apart from a group of some 30 commandos nursing SR-25 semi-automatic rifles who had taken position around the United Nations compound, they were nowhere to be seen.

Most of them were holed up at the airport, awaiting orders to move into town. The people of Dili, those who remained, formed groups. They held machetes, spears, sticks, swords, lengths of wood with long nails and slingshots that fired deadly iron darts. They wore long coats to protect themselves from being slashed. They were standing their ground, protecting themselves from marauders. Or were they the marauders? It became impossible to tell.

In the inner-city suburb of Villa Verde, a house belonging to a family from the east of the country was torched by Timorese from the country's west in a revenge attack for house burnings the day before. Women clutching statues of the Virgin Mary fled, screaming and crying in disbelief at the hate that had suddenly re-entered their lives.

A truckload of people trying to get out of the tight laneways became trapped. They were easterners. Or was that westerners? They were set upon, masked men smashing into the young men in the truck.

As the house burned and another caught fire, there was no question of a fire brigade. Or army intervention. Further to the west of town, in the so-called Delta suburbs – a series of little villages – terror struck just before midday. A house was torched and the panic contagion gripped again. The first company of Australian regulars to hit the city, numbering 70, were pointed to the action by desperate civilians.

The Australians headed for the foothills and separated two warring factions. The soldiers crossed a no-man's land and ordered the westerners to disperse. The group of easterners, held back by the Australians, watched in horrified frustration as the westerners, instead of disbanding, went straight back into the Delta village and set more houses alight. They howled as they watched the group stealing their belongings. They begged the army to intervene. The soldiers would not do it.

"This is no easy decision," said a soldier, watching houses catch alight. "There's no easy way out of it." It seemed they had orders to separate people, but not to disarm them or take any preventative action. An easterner began chanting: "Aussie no good, Aussie no good."

Next to me, a soldier collapsed on top of his rifle. His comrades slapped him back to life and removed his heavy camouflage gear. It was just the heat.

Moving back east into town, the scene turned spooky. Motorbikes burned on the roads; there were blockades everywhere. Driving past groups of men, you'd give them a cautious wave. They'd wave back and usher us through. It was clear white foreigners were not yet a target. Who were these people? Sometimes east, sometimes west, sometimes both. Shooting off to the right, house burning to the left. It was not quite civil war, but it was close.

What was once a petty argument about discrimination has turned the nation toxic. The story, in brief, goes like this: in March, 600 F-FDTL (army) soldiers – known as the petitioners, all of them from the west of the country – abandoned their barracks complaining they had been overlooked for promotions.

Easterners, who run East Timor's military as a reward for leading the 24-year insurgency against the Indonesians, made some stupid remarks about how westerners were Indonesian collaborators.

Early last week, Reinado came down to Dili, by arrangement, to meet political leaders to negotiate a truce. He was fired upon by F-FDTL soldiers. He lost three men and then returned to the hills. Then, on Thursday, things turned very nasty.

The Dili-based police, mostly western-born, were holed up in their barracks in the city, fearful of coming out. Word had got around that the government-loyal eastern troops, who were by then controlling Dili, were going to raid and massacre police. The United Nations intervened, negotiating for the police to lay down their arms and leave the barracks to walk several blocks to the UN compound. The UN had been given assurances by F-FDTL that the police would be allowed to surrender in peace.

As some 70 unarmed police wearing their body armour walked past, accompanied by unarmed UN guards, F-FDTL soldiers opened fire, murdering ten policemen and policewomen; they simply mowed them down. In the hospital ward the following day, the wounded police were lying around in terrible heat, mouths agape and glassy eyed, family members fanning their brows and nuns whispering prayers.

There was a horribly distressed Chinese-Sulawesi bloke with a bullet in his neck and arm – where did he fit into this? It turned out he was the owner of a little red truck we'd seen on a main road, riddled with bullets, blood everywhere. He'd just been in the wrong place at the wrong time.

Australian surgeon Dr David Hamilton said Dili hospital was coping well, although they wanted to get people to Australia. Over the previous days, he and his team and performed 24 operations. What he noticed about the wounds – different to what he'd seen in the Vietnam War and in Pakistan conflicts – was how much messier they were.

"Bullets used to be big and slow," he said. "These were smaller, higher-velocity bullets – they're much more destructive."

Hospital director Antonio Caleras begged us to pass a message to the Australians to come and protect the hospital. He said he'd received threats all through the night that soldiers were coming to finish off the police for good. The message was duly passed on, but it took another day and night before the Australians posted a guard.

By Friday, not a single policeman could be seen in Dili. They had fled to the hills, or were hiding in their homes. The F-FDTL appeared to be confined to their barracks, although to the east of town, in Taci Tolu, they were patrolling and had taken over a deserted barracks there.

The Bulletin met Lieutenant Colonel Aluk Joao Miranda, an easterner, in the barracks. I noticed my translator was looking very nervous and asked what was wrong. "I am worried," he said. "I know these soldiers; they are all from the east. They know I'm from the west ..."

As we talked to Aluk, the translator was heaving with fear. How could that be? Aluk was one of the heroes of the guerilla insurgency – and was, until a few weeks ago, a national hero. Now, he was tarred with the dirty reputation his army has suddenly and justifiably earned. Aluk said he was glad the Australians were here. He said he and his men had in the past days been fighting unreported battles, just to the west of Dili.

Aluk said one of his men had been killed while his men had killed four during the week. Who were they? "They are an unrecognised group," he said, confirming they were westerners.

Seeking the soldiers' protection was a large group of eastern-born police, now at war with the majority western-born police. I put it to Aluk that, sooner or later, he and his men would have to be disarmed by the Australians. "I say there is no fundamental reason to disarm F-FDTL," he said.

To get to President Xanana Gusmao's compound in Dare, in the hills above Dili, we passed through roadblocks manned by police and encountered heavily armed police all the way up. They now controlled these hills. They were protecting Gusmao, and themselves. This was weird – wasn't Gusmao the supreme commander of the military? Why was he now being guarded by both regular and rapid-response police?

It was because Gusmao had expressed his disgust at the army for shooting at unarmed police and petitioners. Now, having aggravated the army, the police have given Gusmao their undivided loyalty.

Rumours have been flying around that the president has cancer and is near death. We saw him and he looked fine – and we are reliably informed his problem is slipped discs and hernias.

Sitting in the president's compound was a small, unassuming man whom I failed to recognise at first: Paolo Martins, East Timor's commissioner of police. He said that of the 3000 police in East Timor, most were loyal to the west. Over the past few days, 700 had fled Dili and were now in position above the city, waiting, but fully prepared to fight the army if necessary. He said he was sickened that the army had ambushed and executed his men on Thursday.

He accused the F-FDTL of opening the armouries of their Bacau and Metinaro barracks, in the east, and distributing automatic weapons to civilians.

That, he said, accounted for the strange masked militia wandering Dili's backstreets, and in towns out of Dili. "I know they have done this; people saw them do it and I have evidence," said Martins.

He was scathing about the UN's failure to protect the policemen who were cut down on Thursday. "They were killed at the hands of the UN," he said.

Martins said it brought back memories of 1999, when the UN abandoned the country after the disastrous autonomy vote. The UN, whose few hundred staff have mostly evacuated apart from "essential" staff, carry no weapons. They were never able to offer the shot police any protection at all. Martins wants the UN, and the soldiers who fired on his men, dealt with as criminals.

By the weekend the battle had evolved into an ethnic clash between civilians. Martins said he feared: "Dili may never be safe again". In all of this, the government – led by Prime Minister Mari Alkatiri – claimed it still had a role to play, but the truth is that Alkatiri lost power late last week. There was, and is, no government.

Alkatiri just wouldn't admit it. John Howard all but called on Alkatiri to throw in the towel.

This cold little man said on Saturday afternoon that he would not resign; rather, the country could wait till the elections next year to decide the leadership. His arrogance was breathtaking.

He and Gusmao are openly hostile, the president calling Alkatiri "stupid" and accusing him of being a communist.

At midnight on Saturday, Gino Favaro, owner of the Hotel Dili and a man who has been in East Timor for all of the troubles of the past 30 years, took The Bulletin for a cruise through town. We had heard the Australians were fully positioned throughout the capital. It was not the case. We only saw four Australians on the streets – sitting concealed in grassy gutters near the F-FDTL compound. "I count more dogs than Australians," said Favaro. The city was utterly deserted.

By Sunday morning, things had changed. Australian soldiers were everywhere and the city was secure.

Or so they said. Major Reinado was meanwhile in Maubisse, to the south of the city. "What am I doing? We're relaxing, cleaning weapons, that's all, awaiting orders from my president," he said.

Reinado has become the figurehead for the west, as the Australians acknowledged on Saturday when 12 soldiers and a lieutenant colonel ("I forget his name," said Reinado) flew up to see him in Black Hawk helicopters. "We had a glass of wine," Reinado said. "We talked." The Australians left, seemingly content just to make contact. The group was not asked to surrender its weapons.

Reinado fully expects Gusmao will, any day now, exercise his right to dissolve the parliament and call for elections. He wants the leaders of the army – namely Brigadier Taur Matan Ruak and his chief-of staff, Lere Anan Timor – charged as criminals for being in charge while their soldiers fired at unarmed people.

He also wants Alkatiri sacked, but advised the prime minister to leave the country for his own safety. "He has to leave. The people are going to cut his head off. They do not like him. Mari is the new Hitler."

On Sunday morning, The Bulletin tried to speak to Alkatiri at his heavily guarded (by eastern-born police) home near the waterfront. He would not appear but sent Australian-trained lawyer Jose Teixeira – one of his closest advisers – out for a chat.

Asked who was in charge of this country, Teixeira said: "The prime minister, of course. Who do you think?" I told him no one was in charge. The place was lawless.

"There is no power vacuum in this country," he insisted. "There is a security vacuum. The Australians have been too slow to get on the ground; they are not handling this well." Then Teixeira spun a line. "There is no rift between the prime minister and the president.

They are in close touch and the prime minister is controlling this whole situation." In fact, Gusmao has seized control of all security forces, rendering Alkatiri powerless. They clearly hate each other.

Teixeira said there was no problem, really, just some unruly youths who needed to be brought into line. He said, after all, the power was on and water was running, wasn't it? Then he told us that the police had been disarmed. It was not true. We drove up the hills and saw many armed police, and confirmed that at least 1000 of them are armed and consider themselves loyal to Gusmao, Reinado and to the westerners in general.

Interior (or Police) Minister Rogerio Lobato has not been sighted in days. He no longer commands the police – his deputy, Alcino Barris, does. Barris is up in the hills with Paolo Martins.

In the suburb of Bairo Pite, around midday on Sunday, we watched some 100 people smashing cars.

Where were the Australians? Although there were said to be 1300 to 1400 Australians on the ground in Dili by then, we circled and circled the city and could see, at most, 100. Spot fires were breaking out across the city.

That morning, Aluk's men had left their barracks, come into town and hijacked an Australian-owned truck, stealing both the vehicle and its load. An Australian officer went alone to talk to Aluk, keeping a guard of Australians well away from any contact with the Timorese soldiers.

Something had gone seriously wrong with the Australian attempt to secure the city. As the commander of Operation Astute, Brigadier Michael Slater, stood in Dili airport claiming the city was under control and imploring the displaced persons who had gathered there to return home, groups were gathering up courage and burning and looting. It seemed they had got the idea that the Australians wouldn't shoot them. They were right.

Late on Sunday afternoon, parts of central Dili were in flames as westerners burned out shops and homes associated with the east. We asked a man what was going on. He delivered a quaint Timorese parable: "Before, the hen [easterners] was fucking the rooster. Now the rooster is fucking the hen."

As the crowd circled on a roundabout in the centre of the city, troops moved in – but stood back as they smashed buildings and set them alight. One Australian soldier lost it, unable to handle the apparent impotence of his unit: "This army's fucking bullshit," he yelled.

I asked another soldier if the rules of engagement said they could do nothing? "We could stop them," he said, "but it's unwise to. At the moment, they outnumber us." To their credit, they acted as peacemakers not aggressors.

Finally, a decision was made to start disarming and detaining the vandals. Two were put on the ground and cuffed with cable ties. Other arrests followed. They were led off, dwarfed by the giant Australians in khaki. They were children.

By Sunday night, it was westerner civilians – not Australian or Malaysian military – controlling Dili.

By Monday lunchtime, police in the hills were surrendering and being trucked by Australian troops to police headquarters. The Timorese army had left town after being ordered back to barracks in the country's east.

Earlier that morning, Gusmao, Alkatiri and the East Timor State Security Council gathered in the president's Dili office. Many saw it as an attempt by Gusmao to overthrow Alkatiri. At 2pm, Gusmao emerged, pushing aside journalists and demanding to speak to "the people". He told the gathering there was no solution and he promised that, whatever happened, he would fix his country's problems. As Gusmao went back into the building, he needed the support of his personal bodyguard, who almost carried him.

The meeting dragged on into stalemate, Alkatiri insisting the president had no power to dismiss him summarily. He was right.

Up in the hills, Sister Lourdes of the Brothers and Sisters in Christ, wept: "My baby country needed good parents. Mari Alkatiri doesn't have the heart to be a good father."