The news came as Iraqi Prime Minister Nouri Maliki visited the UAE
The United Arab Emirates has cancelled the entire debt owed to it by Iraq - a sum of almost $7bn (£3.5bn) including interest and arrears.
The Gulf state also appointed a new ambassador to Iraq, in a move which eases Baghdad's diplomatic isolation.
The news was announced during a visit by Iraqi Prime Minister Nouri Maliki.
Correspondents say Iraq's Sunni Arab neighbours have been wary of fostering ties with Iraq's mainly Shia government because of its links with Iran.
Last month, the UAE's foreign minister became the highest-ranking official from an Arab nation to visit Iraq since the US-led invasion in 2003.
The US has been pushing its Arab allies to send ambassadors to Iraq to bolster Mr Maliki's government.
Soon after Mr Maliki arrived on his two-day visit, the UAE named its former envoy to India, Abdullah al-Shehi, as its new ambassador to Baghdad.
The BBC's Jim Muir in Baghdad says the debt cancellation is a welcome move for Iraq.
Like other Sunni Arab states, the UAE had downgraded its representation in Baghdad, in part because of the security situation - a number of Arab diplomats had been kidnapped or killed.
That downgrading also reflected unease that the Iraqi government seemed to be dominated by Shiites and Kurds, who are minorities in the wider Arab world, our correspondent says.
But the recent Iraqi government crack-down on Shia militias, especially the Mehdi Army of Moqtada Sadr, has impressed Iraqi Sunnis, and their sympathisers beyond the borders, he says.
This means the Baghdad government believes it is a good moment to push for better relations with the Arab states, our correspondent adds.
Mr Maliki used a UN forum on Iraq, held in May, to call for debt cancellation, mainly from Arab nations.
Iraq's debt has been reduced by about $66.5bn over the past three years, not taking into account Sunday's announcement by the UAE, according to the US state department.
Of that, the Paris Club of 19 developed countries cancelled some $43.2bn.
Iraq's foreign debts currently total up to $80bn, Reuters news agency says, with Saudi Arabia and Kuwait among the biggest creditors.
In another sign that its diplomatic isolation may be easing, the Iraqi government has said it expects a visit soon from Jordan's King Abdullah.
He would be the first Arab head of state to visit Iraq since the 2003 invasion.