British forces have withdrawn from a base in Basra they shared with Iraqi police - the first step in a plan to move out all troops based in the city.
A witness said the Mahdi Army took over police headquarters
Another 500 troops will now pull back from Saddam Hussein's former palace, their only remaining base in the city.
In future, British forces will be based at an air station just outside Basra.
The MoD said Basra does not have the heavy fighting experienced in Baghdad and Iraqi forces are demonstrating that they can take the lead in the city.
The MoD said in a statement: "There had been a small presence up to now of British forces in the PJCC (Provincial Joint Coordination Centre) for the support and mentoring of Iraqi police.
"Last night these forces were moved from the PJCC in the framework of the plan for the handover of the Basra Palace to Iraqi control, though British forces currently remain at the palace base."
Between 50 to 60 British troops and Iraqi police were based at the police headquarters, while around 500 UK service personnel remain at Basra Palace.
The overnight withdrawal led to confused reports about who now controlled the police headquarters.
The British military spokesman in Basra has dismissed reports that Shia militia men from the Mahdi Army took over the base after British forces passed control to Iraqi police last night.
Witnesses told the Associated Press the Mahdi Army emptied the building taking generators, computers, furniture and even cars.
Major Michael Shearer told the BBC News website that officers from the Multi-National Force spoke to the local Iraqi Army commander who "assured us that the PJCC is under his control and being efficiently run by the Iraqi Army. He also stated that all the equipment remains within the PJCC".
An MoD spokesman said there was a green Shia flag flying on the building, but not the black flag associated with the Mahdi Army.
There are now about 5,500 UK troops in Iraq - mostly based at Basra Airport.