The provincial council in Basra, southern Iraq, has suspended relations with UK forces over a video appearing to show troops abusing Iraqi civilians.
The images have been broadcast in the Middle East
This comes after the News of the World carried images on Sunday that it said came from a video shot in 2004.
Royal Military Police are continuing to question a soldier over the footage.
Two Iraqi civilians who claim they were beaten by UK soldiers in 2004 say they are to take legal action against the British military for compensation.
Bassem Shaker, 27, and a 14-year-old say they were among nine people beaten after a demonstration in Amarah.
The BBC's Jonathan Charles said it was not clear if the pair were among those seen in the video obtained by the News of the World.
Royal Military Police are questioning Cpl Martin Webster of 1st Battalion The Light Infantry, who was arrested on Sunday.
The Ministry of Defence has not confirmed if Cpl Webster is being questioned as a witness or a suspect.
The MoD said other members of the same unit were "helping with inquiries".
Capt James St John-Price in Basra said the provincial council severed contact on Monday.
"We are unsure if this includes diplomatic and economic ties also," he told the Associated Press news agency.
The council is expected to be sending out letters on Tuesday to the police service and other subordinate organisations in Basra calling for a policy of non-cooperation with British troops.
Squadron Leader Mark Alker said: "We are going to have to see what the level of response by Iraqis is to this.
"We are continuing to help and work alongside the police and Army and carry out reconstruction work."
Mr Shaker claims he was part of a 250-strong demonstration in the city of Amarah on 10 January 2004 about unemployment.
He says that after protesters threw stones at UK troops, the forces fired rubber bullets to disperse the crowd then arrested nine people and beat them with fists and batons.
The Iraqi said he had not previously reported the alleged abuse because he thought nothing would be done.
But "when we saw this tape and the amount of anger it caused inside and outside Iraq", he changed his mind, he said.
The Ministry of Defence said it was not yet certain which units were shown in the video.
But it is thought the apparent abuse happened during the deployment of 20 Armoured Brigade.
As well as 1st Battalion The Light Infantry, it included 1st Battalion the Royal Regiment of Wales, the Queen's Royal Hussars and 26 Royal Artillery.