Six members of the UK's Royal Military Police force were killed outside a police station in the Iraqi town of Majar al-Kabir, north of Basra.
Four of the soldiers were killed in this room
Although accounts of what happened are still confused, local people suggest it was a search for weapons that triggered a shoot-out.
The incident appears to have happened when the six British military policemen were attempting to search homes in the town for heavy weapons on Tuesday.
The BBC's Clive Myrie, who has been to the town, said tensions had been running high over the way house searches had been carried out.
Salah Mohammed, a local community leader appointed by British soldiers, told the BBC troops had begun to ignore a written agreement, signed by both sides, that they would give adequate notice before they searched people's homes for illegal weapons.
BRITISH TROOPS UNDER FIRE
British military policemen carry out house searches
Angry crowd gathers to protest at intrusive search
Locals say British soldiers fire on crowd in market place
Troops take refuge in disused police station
Crowd storms police station killing military policemen
The AFP news agency says locals were also angered by the British soldiers' use of dogs during their searches.
"We are a Muslim country and we cannot accept the British entering and searching our houses with dogs," Saad Hussein told AFP.
The British military deny any heavy-handed search tactics and say they have always tried to observe Muslim customs while carrying out their investigations.
But Mr Mohammed said hundreds of people angered by the searches followed the soldiers to a market place.
A demonstration then began and shooting broke out.
It is unclear who started firing first, but a local Iraqi policeman told news agencies that the soldiers shot dead four of the demonstrators.
Several witnesses told BBC correspondent Peter Greste that the troops may have fired a warning shot in an attempt to disperse the crowd.
Other local people say the military policeman opened fire during the demonstration, although it is not clear whether they used live ammunition or rubber bullets.
The military police were then forced to retreat to the abandoned police station before the angry crowd stormed the building.
"By all accounts the attack on the police station was frenzied," the BBC's Clive Myrie said.
Scores of people armed to the teeth flooded the building, the policeman didn't stand a chance
"Scores of people armed to the teeth flooded the building.
"The British military policeman taking cover there didn't stand a chance."
The building was then set on fire.
A spokesman for the British forces has described the attack as "unprovoked murder".
UK Prime Minister Tony Blair said locals in the Majar al-Kabir routinely carried machine guns and small firearms and there had been problems with attempts by British forces to disarm them.
"There have been problems in relation to that and that may form part of the background to it," Mr Blair said.
Mr Blair said more details should become clear in the next 24 hours, but a "background" of problems in the province could have contributed to the deaths.
The town had already witnessed an attack on British troops when two British vehicles came under attack earlier in the day.
Troops from the 1st Battalion the Parachute Regiment came under attack from rocket propelled grenades, machine guns and rifles while on patrol in the town from a large number of Iraqi gunmen, according to British military sources.
A quick reaction force, including a troop of Scimitar armoured vehicles and a Chinook helicopter, were called in to help but also came under fire.
Seven men in the helicopter and one man on the ground were injured in the