Iraq says it will close the offices of the Kurdistan Workers Party (PKK) rebel group and will "not allow it to operate on Iraqi soil".
The PKK has been stepping up attacks on Turkish troops
Prime Minister Nouri Maliki said he would also "work on limiting its terrorist activities which are threatening Iraq and Turkey".
The PKK has been blamed for a number of recent deadly raids inside Turkey.
Turkey has come under intense public pressure to use force after its parliament approved cross-border raids.
Prime Minister Recep Tayyip Erdogan said Ankara was considering sanctions on Iraq over incursions by the PKK.
The US military commander in Iraq, Gen David Petraeus, has told the BBC it would be very difficult for anyone to police Iraq's northern border but pressure should be put on the PKK.
Mr Maliki said in Baghdad after meeting visiting Turkish Foreign Minister Ali Babacan: "The PKK is a bad terrorist organisation and we have taken a decision to close its offices and not allow them to work on Iraqi soil."
Mr Babacan earlier said Turkey would put the emphasis on a diplomatic solution.
"Politics, dialogue, diplomacy, culture and economy are the measures to deal with this crisis," he said.
Mr Babacan rejected any ceasefire with the PKK, saying this was not possible with a "terrorist organisation".
In the past week, Turkey has been building up its military presence on the border with Iraq and, on the other side, PKK rebels have stepped up their attacks against Turkish troops.
There are thought to be about 3,000 PKK rebels based in Iraq.
The rebels claim to have captured several troops following an attack on Sunday that left 12 soldiers dead. The Turkish military says eight soldiers are missing.
Tens of thousands of Turks protested across the country on Tuesday during the funerals of the troops who were killed.
About 10,000 people attended the funeral of Vedat Kutluca in Keskin, 100km (62 miles) east of Ankara.
The Anatolia news agency said 50,000 marched in the western city of Aydin.
In London, Mr Erdogan said: "We may impose some sanctions with respect to some goods we export to Iraq."
He did not specify what might be embargoed but mentioned Turkey had been helping Iraq with water, fuel and food.
"I believe the countries who believe in fighting jointly against terrorism will understand this response, if we choose to display it, because terrorism is a scourge for mankind."
At a news conference with UK Prime Minister Gordon Brown, Mr Erdogan said Turkey had no territorial designs on Iraq.
But he added that the Turkish military could use force against the PKK "at any time" if Baghdad failed to act.
Speaking to the BBC World Service, Gen Petraeus pointed out the difficulty of carrying out operations in the border mountains.
"It's really in a tri-border area where the recent clashes took place, with Turkish, Iraqi and Iranian borders in that location, in extreme terrain for carrying out operations," he said.
He suggested that Kurds in the north of Iraq had channels of communication to the PKK and should use them to dissuade them from further attacks.
They could, he said, "get them [the PKK] to step back off the ledge... and not make a very difficult situation worse than it already is".
The commander added that the US had found itself in an "exceedingly difficult position" between Nato ally Turkey and Iraq, an ally in the fight against "difficult insurgent enemies".