diff --git a/mercurial/context.py b/mercurial/context.py
--- a/mercurial/context.py
+++ b/mercurial/context.py
@@ -697,7 +697,11 @@
     def matches(self, match):
         return self.walk(match)
 
-class basefilectx(object):
+class abstractfilectx(object):
+    def data(self):
+        raise error.ProgrammingError("Must be implemented by subclasses")
+
+class basefilectx(abstractfilectx):
     """A filecontext object represents the common logic for its children:
     filectx: read-only access to a filerevision that is already present
              in the repo,
@@ -858,6 +862,9 @@
             or self.size() == fctx.size()):
             return self._filelog.cmp(self._filenode, fctx.data())
 
+        if isinstance(fctx, abstractfilectx):
+            return self.data() != fctx.data()
+
         return True
 
     def _adjustlinkrev(self, srcrev, inclusive=False):
@@ -2124,6 +2131,9 @@
         self._parent = parent
         self._path = path
 
+    def cmp(self, fctx):
+        return self.data() != fctx.data()
+
     def ctx(self):
         return self._parent
 
diff --git a/mercurial/filemerge.py b/mercurial/filemerge.py
--- a/mercurial/filemerge.py
+++ b/mercurial/filemerge.py
@@ -7,7 +7,6 @@
 
 from __future__ import absolute_import
 
-import filecmp
 import os
 import re
 import tempfile
@@ -226,9 +225,9 @@
         return '\n'
     return None # unknown
 
-def _matcheol(file, origfile):
+def _matcheol(file, back):
     "Convert EOL markers in a file to match origfile"
-    tostyle = _eoltype(util.readfile(origfile))
+    tostyle = _eoltype(back.data()) # No repo.wread filters?
     if tostyle:
         data = util.readfile(file)
         style = _eoltype(data)
@@ -468,6 +467,12 @@
     a = _workingpath(repo, fcd)
     fd = fcd.path()
 
+    # Run ``flushall()`` to make any missing folders the following wwrite
+    # calls might be depending on.
+    from . import context
+    if isinstance(fcd, context.overlayworkingfilectx):
+        fcd.ctx().flushall()
+
     util.writefile(a + ".local", fcd.decodeddata())
     repo.wwrite(fd + ".other", fco.data(), fco.flags())
     repo.wwrite(fd + ".base", fca.data(), fca.flags())
@@ -505,7 +510,9 @@
 
         args = _toolstr(ui, tool, "args", '$local $base $other')
         if "$output" in args:
-            out, a = a, back # read input from backup, write to original
+            # read input from backup, write to original
+            out = a
+            a = repo.wvfs.join(back.path())
         replace = {'local': a, 'base': b, 'other': c, 'output': out}
         args = util.interpolate(r'\$', replace, args,
                                 lambda s: util.shellquote(util.localpath(s)))
@@ -588,10 +595,10 @@
 def _restorebackup(fcd, back):
     # TODO: Add a workingfilectx.write(otherfilectx) path so we can use
     # util.copy here instead.
-    fcd.write(util.readfile(back), fcd.flags())
+    fcd.write(back.data(), fcd.flags())
 
 def _makebackup(repo, ui, fcd, premerge):
-    """Makes a backup of the local `fcd` file prior to merging.
+    """Makes and returns a filectx-like object for ``fcd``'s backup file.
 
     In addition to preserving the user's pre-existing modifications to `fcd`
     (if any), the backup is used to undo certain premerges, confirm whether a
@@ -600,12 +607,27 @@
     """
     if fcd.isabsent():
         return None
+    from . import context
+    back = scmutil.origpath(ui, repo, repo.wjoin(fcd.path()))
 
-    a = _workingpath(repo, fcd)
-    back = scmutil.origpath(ui, repo, a)
-    if premerge:
-        util.copyfile(a, back)
-    return back
+    inworkingdir = (back.startswith(repo.wvfs.base) and not
+        back.startswith(repo.vfs.base))
+
+    if isinstance(fcd, context.overlayworkingfilectx) and inworkingdir:
+        # If the backup file is to be in the working directory, and we're
+        # merging in-memory, we must redirect the backup to the memory context
+        # so we don't disturb the working directory.
+        relpath = back[len(repo.wvfs.base) + 1:]
+        fcd.ctx()[relpath].write(fcd.data(), fcd.flags())
+        return fcd.ctx()[relpath]
+    else:
+        # Otherwise, write to wherever the user specified the backups should go.
+        #
+        # A arbitraryfilectx is returned, so we can run the same functions on
+        # the backup context regardless of where it lives.
+        if premerge:
+            util.copyfile(_workingpath(repo, fcd), back)
+        return context.arbitraryfilectx(back)
 
 def _maketempfiles(repo, fco, fca):
     """Writes out `fco` and `fca` as temporary files, so an external merge
@@ -719,7 +741,7 @@
         return True, r, deleted
     finally:
         if not r and back is not None:
-            util.unlink(back)
+            back.remove()
 
 def _check(repo, r, ui, tool, fcd, files):
     fd = fcd.path()
@@ -741,7 +763,7 @@
     if not r and not checked and (_toolbool(ui, tool, "checkchanged") or
                                   'changed' in
                                   _toollist(ui, tool, "check")):
-        if back is not None and filecmp.cmp(_workingpath(repo, fcd), back):
+        if back is not None and not fcd.cmp(back):
             if ui.promptchoice(_(" output file %s appears unchanged\n"
                                  "was merge successful (yn)?"
                                  "$$ &Yes $$ &No") % fd, 1):
diff --git a/tests/test-dirstate-race.t b/tests/test-dirstate-race.t
--- a/tests/test-dirstate-race.t
+++ b/tests/test-dirstate-race.t
@@ -80,9 +80,9 @@
 
   $ hg status --config extensions.dirstaterace=$TESTTMP/dirstaterace.py
   M d
-  M e
   ! b
   ! dir1/c
+  ! e
   $ hg debugdirstate
   n 644          2 * a (glob)
   n   0         -1 unset               b