Swords, wooden sticks and rocks were used in the street battle, leaving at least eight people injured. At least one man suffered severe injuries to his hand after being hit with a sword.
A Reuter's press agency photographer was repeatedly beaten by a mob and his camera taken away before he was rescued by police.
It was not immediately clear if any police officers were injured as they tried to separate the two sides, but some were seen with blood-stained uniforms at the scene.
"Both sides were at each others throats, and they even attacked police as they tried to get the crowds away from each other. We (our family) were scared, and we are terrified now of what will happen next," a female resident who wished not to be named told DPA at the scene.
Initial reports suggest that the fight started earlier Thursday between children from a recently naturalized Arab family and Shia students at their school, before quickly escalating overnight to a neighbourhood fight between the two sides.
Anti-riot police moved in to seal off the neighbourhood where the clashes erupted and act as a buffer between the two sides, after hundreds of people from a nearby Shia village gathered following rumours that there were deaths during the clashes.
The area is considered a flashpoint for clashes between Shias and newly naturalized Sunni Arabs, who are viewed by the Shias as part of an alleged government plan to marginalize them and change the country's demography. In the last two years, several serious clashes had erupted in the area along sectarian lines.
Thursday night clashes, however, were the first clashes between two sides considered on opposite ends of the political spectrum in a country that has been embroiled for the three weeks in protests calling for reforms.
Bahrain's interior minister, Sheikh Rashid bin Abdullah al-Khalifa, inspected the area shortly after the clashes erupted, meeting with officers on the ground and some of the areas residents.
Al-Wefaq society, the largest Shiite opposition grouping, issued a statement late Thursday declaring Sunni-Shia unity and calling on residents in the area to maintain calm. The statement warned of attempts to draw the public in a "direction that harms national unity."
"Residents should be cautious to anything that could be detrimental to national unity and creates sedition amongst the Bahraini society," Al-Wefaq said, warning that "there are forces that wish to sow discord and sedition among the country's sons."
Shia Muslims make up more than 70 percent of Bahrain's population, but the ruling family is Sunni Muslim.
Manama's Lulu Square has been the focal point of protests that have swept the small Gulf island since Feb 14, inspired by successful anti-government movements in Tunisia and Egypt.