More Iraqi soldiers are expected to take up positions left by US marines in the city of Falluja on Saturday.
There were scenes of celebration as US troops began pulling back
The first 200 soldiers in the Falluja Brigade, led by an ex-Republican Guard general, arrived on Friday night.
The coalition hopes the new force of about 1,000 men will win the trust of residents in a city that has seen weeks of bloody clashes with rebels.
But US commanders say the Falluja Brigade will not necessarily calm the situation in the city immediately.
The Americans say they will remain a presence in Falluja until the Iraqi force shows it can control checkpoints and other critical areas there.
Crowds cheered on Friday as US marines rolled up their barbed wire fencing, dismantled checkpoints, and pulled back to positions outside the city.
But even as the withdrawal got under way, two American soldiers were killed in a roadside bomb attack near the main US military base outside Falluja.
Gen Jasim Mohamed Saleh, who used to command a brigade of Saddam Hussein's elite Republican Guard, said he was forming "a new emergency military force" that would help bring order to the city.
He said the force of about 1,000 would operate "without the need for the American army, which the people of Falluja reject".
It will, however, remain answerable to the US military and marine officials say they will evaluate its performance daily.
US military spokesman Brig Gen Mark Kimmitt says marines have vetted Gen Saleh and have confidence in him.
He vehemently denied marines had been forced into retreat.
"We are certainly not withdrawing from Falluja. Nothing
could be further from the truth," Brig Gen Kimmitt told a Baghdad news conference.
He said the US was sticking by its demands for local people to hand over the killers of four US contractors.
But both Falluja residents and Gen Saleh's soldiers paraded the old Iraqi flag - an apparent act of defiance against the US-appointed governing council which approved a new flag only days ago.
The triumphalist jubilation does not bode well for the interim council or the coalition authority, says the BBC's Magdi Abdelhadi.
Falluja, a predominantly Sunni Muslim city of 300,000 people 50km (30 miles) west of the capital Baghdad, has been a centre of resistance to the US-led occupation of Iraq.
Heavy explosions to the east of the city showed fighting continued on Friday, Reuters news agency reported.
Two marines were killed and six wounded in a suicide car bomb close to their base there.
Doctors in Falluja say 600 people have already been killed and thousands have fled the city since the siege began on 5 April.
Firebrand Shia cleric Moqtada Sadr attacked the decision to mobilise the Iraqi force at Friday prayers in Kufa, outside Najaf.
"They are trying to reintegrate the Baathists. It proves the Americans hate the Iraqi people," Mr Sadr told worshippers.
The US has vowed to kill or capture Mr Sadr and destroy his Mehdi army, which has been fighting coalition forces.