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US administrator Paul Bremer transferred sovereignty to an Iraqi judge at a handover brought forward two days in an attempt to prevent the occasion being marked by bloodshed.
Mr Bremer flew out of the country shortly after. His departure ends 15 months of US control in Iraq.
Iraq's interim Prime Minister Iyad Allawi, who attended the handover in the city's heavily-guarded "Green Zone", said it was an "historic day" for Iraq.
Mr Allawi's cabinet were sworn in at a later ceremony, also held in secret.
The new prime minister made a televised address after formally taking office.
He told Iraqis: "I call on our people to stand united to expel the foreign terrorists who are killing our children and destroying our country."
Although power is back in Iraqi hands, US President George Bush said American troops would remain in the country as long as they were needed.
The president added that US presence would also be at the request of the newly-formed interim government.
Mr Bremer defended his country's reasons for being in Iraq, referring to recently discovered graves where thousands victims of Saddam Hussein's regime are believed to be buried.
The former Coalition Provisional Authority administrator said: "Anybody who has any doubt about whether Iraq is a better place today than it was 14 months ago should go down and see the mass graves in Hilla.
"Anybody who has seen those things that I have will know that Iraq is a much better place."
The power handover was welcomed by world leaders. The European Union and Nato alliance both pledged their support for Mr Allawi's government.
Mr Bush and Mr Blair were apparently the only leaders at the current Nato summit who knew the transfer of sovereignty would take place early.
The news was revealed by Iraqi foreign minister Hoshyar Zebari, speaking after talks with the UK prime minister.
Bringing the handover forward and holding it in secret meant the transfer of power was not marked by attacks by insurgents.
But frequent attacks on US and UK forces as well as on Iraqi civilians have continued to take place in the country.
Neither the US nor Britain have yet committed to a date when troops will be removed.
Iraq held its first multi-party elections in 50 years in January 2005. An interim democratically elected government was sworn in on 3 May 2005 with Shia Ibrahim Jaafari as prime minister.
But finding an acceptable balance of power in the government between Iraq's national groups has proved difficult.
In December 2005 Iraqis voted for the first full-term government since the American-led invasion.
In January 2006 the Shia-led United Iraqi Alliance emerged as winners of the elections but without an absolute majority.
After four months of deadlock, President Talabani asked Shia compromise candidate Jawad al-Maliki to form a new government.
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