The unrest against UK troops in Basra shows Iraq is moving towards civil war, Lib Dem leader Charles Kennedy says.
British soldiers had to jump from their burning armoured vehicle
He said the most worrying thing was the apparent "breakdown in trust" between UK and Iraqi security forces.
And Lib Dem campaigns chief Lord Razzall said he feared current policy was "a recipe for an eventual Vietnam".
But Defence Secretary John Reid insists the situation in Iraq is not all gloomy and argues the UK must not be "cowed to the men of violence".
Crowds on Monday attacked UK armoured vehicles as they tried to free two soldiers arrested by Iraqi police.
UK forces broke into Basra prison. The MoD said the soldiers were later found at a nearby house as they had been handed by Iraqi police to Shia militiamen.
Basra governor Mohammed al-Waili called the Army action a "barbaric act of aggression".
Lord Razzall on Tuesday called for a timetable for withdrawing British troops from Iraq.
"We can not just continue with government policy, which is to withdraw troops when the security situation improves," he said.
Mr Kennedy is expected to reinforce that call in his main speech to the party's conference in Blackpool on Thursday.
The Lib Dem leader told reporters: "I think the events of the last 24 hours confirm what many of us have worried now over many months, that Iraq is moving more in the direction of civil war."
Mr Kennedy said the most worrying thing was the "breakdown in communication, trust and co-operation between the British forces - who have done a heroic job there under the most dreadful of circumstances - and aspects at least of the Iraqi domestic security forces".
Earlier, the defence secretary admitted the prison incident was "worrying" but he praised the "fortitude" of the men involved and said the rescue mission had been right.
Mr Reid told BBC News: "We don't actually know the details of why these people were handed over - whether it was under threats or by collusion, or whatever.
"What we do know is that under the law they should have been handed back to the British forces themselves. That is the law which enshrines our presence there."
Mr Reid said there had been "mob violence".
"Our forces did what they do, they stood firm," he said.
The defence secretary was upbeat about the state of Iraqi security forces generally, saying they now outnumbered multi-national troops in the country for the first time since the invasion.
A UK soldier fled his armoured vehicle after petrol bombs were thrown
"Everything is not black there but as we make the advance towards a democracy and build up the security forces, I freely admit that I expect that the terrorists will get more frenetic, more frantic," he said.
Mr Reid said he had already made clear the decision to withdraw UK troops from Iraq would be taken when requested by the democratic Iraqi government.
The withdrawal would be "not an event but a process", he said, but could begin within a year.
Conservative shadow foreign secretary Michael Ancram said he was not asking for a date for the withdrawal of troops.
But he said ministers should explain who would decide when to leave Iraq and on what basis.