(Reuters) - Yemen's President Abd-Rabbu Mansour Hadi was expected to yield to demands on Wednesday for constitutional change and power sharing with Houthi rebels who took up positions outside his home after defeating his guards in two days of battle. Gulf neighbors denounced what they described as a coup in Yemen, although both the Houthis and some of the president's allies denied that he had been overthrown. A source close to the president said Hadi had met an official of the Shi'ite Muslim rebel group and would soon issue decrees resolving all differences. The source denied Hadi was under house arrest inside the residence, surrounded since early morning by Houthi fighters. "Within hours, decisions will be made heeding the Houthi demands," said the source, speaking to Reuters on condition of anonymity before the official announcement. "We expect an announcement to resolve all problems within hours." The Houthis, friendly to Iran, swept into the capital four months ago and have emerged as the dominant force in the country. For now at least they appear to have decided to stop short of overthrowing Hadi, possibly preferring to exert control over a weakened leader rather than take on the burden of power. Their defeat of the presidential guards in gunbattles and artillery duels in recent days adds to disarray in a country where the United States is also carrying out drone strikes against one of the most powerful branches of al Qaeda. The guards' defeat was made possible because the army did not fight, a reflection that Hadi, a former general, secured little lasting power base during his military service while the Houthis have penetrated key institutions since September. After clashes at the president's office and home on Tuesday, the Houthis' leader threatened in a speech overnight to take further "measures" unless Hadi bowed to his demand for constitutional changes that would increase Houthi power. By early morning on Wednesday, Houthi fighters, accompanied by an armored vehicle, had replaced the guards at the president's residence. Presidential guard sentry posts were initially empty, however a few guards later appeared and were permitted to take up positions. "President Hadi is still in his home. There is no problem, he can leave," Mohammed al-Bukhaiti, a member of the Houthi politburo, told Reuters. Prime Minister Khaled Bahah quit his official residence, which had also been surrounded by Houthi fighters, for "a safe place after three days of siege", one of his aides told Reuters. SOUTHERN PROTEST One of Hadi's guards told Reuters that while the Houthis were outside his compound, the president's security men were with him inside. He said Hadi had held meetings with several of his political associates during the day. Yemeni military sources said the Houthis also seized the military aviation college located close to Hadi's home, and the main missile base in Sanaa, without a fight. In the south of the country, Hadi's home region, local officials denounced what they called a coup against him. They shut the air and sea ports of the south's main city, Aden and closed land entry routes. Gulf Arab states, which support Hadi and oppose Iranian influence in the region, denounced what they called terrorist acts by the Houthis and their allies. They demanded state bodies be returned to government control and Hadi's chief of staff, detained by the Houthis last week, be released. Yemen, an impoverished nation of 25 million, has been plagued by Islamist insurgency, separatist conflict, sectarian strife and economic crisis for years. An "Arab Spring" popular uprising in 2011 led to the downfall of long-ruling President Ali Abdullah Saleh, bringing more chaos. The Houthis, rebels from the north drawn from a large Shi'ite minority that ruled a 1,000-year kingdom in Yemen until 1962, stormed into the capital in September but had mostly held back from directly challenging Hadi until last week. They accuse the president of seeking to bypass a power-sharing deal signed when they seized Sanaa in September, and say they are also working to protect state institutions from corrupt civil servants and officers trying to plunder state property. Houthi fighters battled guards at Hadi's home and entered the presidential palace on Tuesday. In his televised speech that followed, the group's leader Abdel-Malek al-Houthi warned Hadi that he had to implement the power-sharing deal. "We ... will not hesitate to impose any necessary measures to implement the peace and partnership agreement," said Abdel-Malek, whose Shi'ite Muslim group is widely seen as an ally of Iran in its regional struggle for influence with Saudi Arabia. REGIONAL POWER The accord gives the Shi'ite Muslim group, which takes its name from the family of its leader, a role in all military and civil state bodies. The Houthis also demand changes to the divisions of regional power in a draft constitution. Their decision to stop short of toppling Hadi, an ally of the West and supporter of U.S. drone strikes, may be intended to keep regional Sunni Muslim states and the United States from rallying against them. A government source told Reuters: “They know that if they bring about the downfall of the president, they won’t be able to rule the country, because Western and neighboring countries will gang on up on them, as well as other provinces that are not under their control.” Abdel-Malek's speech left little doubt however that his movement was now in effective control of the country. Al Masdar newspaper referred to him as "the president's president". SCRAMBLED ALLIANCES The emergence of the Houthis as Yemen's de facto top power in September has scrambled alliances across Yemen's political spectrum, raising fears of deeper instability in a country that shares a border with top oil exporter Saudi Arabia and has one of al Qaeda's most active branches. The Houthi action this week is likely to deepen a regional struggle for influence between Saudi Arabia and Iran, and may complicate the region's counter-terrorism challenge. Angered by the takeover in September, and suspecting Iranian complicity, Riyadh cut most of its financial aid to Yemen. For its part, al Qaeda has launched repeated attacks on Houthi targets, including bombings in Sanaa that have killed civilians and raised fears of widespread sectarian violence. Abdel-Malek al-Houthi, in his early 30s, originally won his reputation as a tough, efficient battlefield commander in a series of six wars fighting Saleh's forces. But since mass protests in 2011, he has positioned himself as a revolutionary national leader, claiming the mantle of the demonstrators who flocked Sanaa's streets four years ago demanding an end to corruption and dictatorial government.