The chain of events with fetchmail goes like this: fetchmail logs into your ISP via POP3 (IP port 110) and retrieves your mail, then it accesses sendmail on the localhost via SMTP (IP port 25) and attempts to deliver the mail. If the connection is accepted then sendmail verifies that the mail is for local delivery and passes it off to the Mail Delivery Agent or MDA (the default MDA is procmail on Red Hat Linux) which places the mail in the destination recipient's mail spool in /var/spool/mail.
Because you're using relay restrictions, sendmail is rejecting connections from localhost because it has not been explicitly told to accept them. To fix it edit /etc/mail/access and add the entry: localhost RELAY. Then run makemap hash /etc/mail/access.db < /etc/mail/access and restart sendmail. When testing fetchmail is always a good idea to issue the fetchmail command with the -v switch so you can see what's happening.