The moves to demobilize were abruptly reversed after the outbreak of war with Ethiopia over the contested border. During the 1998-2000 war, which is estimated to have resulted in well over 100,000 casualties on the two sides, Eritrea's armed forces expanded to close to 300,000 members, almost 10% of the population. This imposed a huge economic burden on the country. The International Monetary Fund (IMF) estimates that the economy shrank by more than 8% in 2000, although it rebounded somewhat in 2001. The war ended with a cessation of hostilities agreement in June 2000, followed by a peace agreement signed in December of the same year. A UN peacekeeping mission, the UN Mission in Ethiopia and Eritrea (UNMEE), was established and monitors a 25-kilometer-wide Temporary Security Zone separating the two sides. Per the terms of the cessation of hostilities agreement, two commissions were established: one to delimit and demarcate the border and the other to weigh compensation claims by both sides. The Eritrea-Ethiopia Boundary Commission announced its decision in April 2002. Demarcation was expected to begin in 2003 but has been delayed by a stalemate between Ethiopia and Eritrea.

The government has been slow to demobilize its military after the most recent conflict, although it recently formulated an ambitious demobilization plan with the participation of the World Bank. A pilot demobilization program involving 5,000 soldiers began in November 2001 and was to be followed immediately thereafter by a first phase in which some 65,000 soldiers would be demobilized. This was delayed repeatedly. In 2003, the government began to demobilize some of those slated for the first phase. The World Bank has not yet approved the demobilization program, and funding for it from other donors is uncertain.

U.S. military cooperation with Eritrea, which was suspended following the outbreak of hostilities with Ethiopia and a UN embargo on military cooperation with either side, has resumed on a modest basis.