Iraq has cancelled the licence of the private security firm, Blackwater USA, after it was involved in a gunfight in which at least eight civilians died.
As many as 20,000 private security contractors are working in Iraq
The Iraqi interior ministry said the contractor, based in North Carolina, was now banned from operating in Iraq.
The Blackwater workers, who were contracted by the US state department, apparently opened fire after coming under attack in Baghdad on Sunday.
Thousands of private security guards are employed in Iraq.
They are often heavily armed, but critics say some are not properly trained and are not accountable except to their employers.
The interior ministry's director of operations, Maj Gen Abdul Karim Khalaf, said authorities would prosecute any foreign contractors found to have used excessive force.
"We have opened a criminal investigation against the group who committed the crime," he told the AFP news agency.
All Blackwater personnel have been told to leave Iraq immediately, with the exception of the men involved in the incident on Sunday.
They will have to remain in the country and stand trial, the ministry said.
The convoy carrying officials from the US state department came under attack at about 1230 local time on Sunday as it passed through Nisoor Square in the predominantly Sunni neighbourhood of Mansour.
The Blackwater security guards "opened fire randomly at citizens" after mortars landed near their vehicles, killing eight people and wounding 13 others, interior ministry officials said.
BLACKWATER USA FACTS
Founded in 1997 by a former US Navy SEAL
Headquarters in North Carolina
One of at least 28 Private Security Companies in Iraq
Employs 744 US citizens, 231 third-country nationals, and 12 Iraqis to protect US state department in Iraq (May 2007)
Provided protection for former CPA head Paul Bremer
Four employees killed by mob in Falluja in March 2004
Personnel have no combat immunity under international law if they engage in hostilities
Most of the dead and wounded were bystanders, the officials added. One of those killed was a policeman.
A spokeswoman for the US embassy in Baghdad later confirmed there had been an incident in which state department security personnel reacted to a car bomb "in the proximity", and that they had been shot at.
"We are taking it very seriously indeed," she told the BBC, adding that discussions were still taking place about Blackwater's status now that they had been ordered to leave.
When asked if Blackwater was complying with the order, the spokeswoman said she could not comment because the investigation into the incident was still in progress.
A spokesman for the US Secretary of State, Condoleezza Rice, said she wanted to ensure that everything was being done to avoid the loss of innocent life and to make sure this kind of incident never happened again.
She is also expected to telephone Iraqi Prime Minister Nouri Maliki to reassure him that the US had launched its own investigation.
Blackwater is reputed to have a contract worth $300m (£150m) with the state department to protect its diplomatic staff and equipment in Iraq.
The company, whose personnel have no combat immunity under international law if they engage in hostilities, has so far refused to comment on the shootings.
Sunday's violence followed the publication of a survey of Iraqis which suggested that up to 1.2m people might have died because of the conflict in Iraq.
A UK-based polling agency, Opinion Research Business (ORB), said it had extrapolated the figure by asking a random sample of 1,461 Iraqi adults how many people living in their household had died as a result of the violence rather than from natural causes.
The results lend weight to a 2006 survey of Iraqi households published by the Lancet, which suggested that about 655,000 Iraqi deaths were "a consequence of the war".
However, these estimates are both far higher than the running total of reported civilian deaths maintained by the campaign group Iraq Body Count which puts the figure at between 71,000 and 78,000.