The man had taken a fare in Letterkenny and was asked to drive to Lifford by two men.
However just a few minutes into the journey the taxi-driver was assaulted and dumped at the side of the road near the Ballyholey Crossroads near Raphoe.
The victim, who was in his 40s, was treated for shock but was not seriously hurt.
The car was later found burned-out close to the border.
The hijacking has shocked local taxi-drivers.
A man in his 20s has since been arrested and has been taken to Letterkenny Garda station.
A second man is still being sought.
A Garda spokesman said “We’ve one man in custody but we’re appealing to anyone who may have saw anything suspicious on the Lifford road between 5 and 6am to contact us.
“His injuries were not serious and he managed to get help before reporting the incident to Gardai in Letterkenny.
“One man in his 20’s was subsequently arrested and taken to Letterkenny Garda Station. However, the second remains at large and a full scale investigation is underway to try and find him,” she added.