Iraq revoked the licence of one of the biggest American security companies in the country yesterday after eight civilians died in a gunfight in Baghdad.

The Interior Ministry said that it would prosecute any foreign contractors working for Blackwater USA found to have used excessive force, and suggested that it would expel hundreds of other employees.

The move would be resisted strenuously by the US Government, whose security arrangements will be thrown into chaos if Blackwater can no longer operate in Iraq. The company has lucrative State Department contracts to protect hundreds of US government officials and dignitaries, including Ryan Crocker, the US Ambassador.

Condoleezza Rice, the Secretary of State, planned to telephone Nouri al-Maliki, the Iraqi Prime Minister, to express regret for the deaths and promise an investigation to ensure there would be no repeat. Mr Maliki called the shootings a “crime”.

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The shootout erupted after a car bomb exploded near a State Department convoy driving through the al-Yarmukh district shortly before 1pm on Sunday. The US embassy said the convoy was attacked by insurgents and its Blackwater security guards returned fire. Witnesses said there was a 20-minute gun battle which left eight civilians dead and thirteen injured. Iraqi officials said most were bystanders.

It was unclear last night whether private security contractors get the same immunity from prosecution as coalition soldiers. Iraqi officials insisted they did not, but orders issued by the Coalition Provisional Authority say they can only be prosecuted with the permission of their own Government.

There are scores of private security companies in Iraq, employing more than 30,000 well-paid, heavily armed ex-soldiers. They speed through crowded streets, forcing Iraqi vehicles off the road. That, and the propensity of some of them to shoot first and ask questions later, has angered Iraqis.

Blackwater is one of the biggest and most controversial of these security companies. In ten years it has grown into what one reporter called the “world’s most powerful mercenary army,” with more than 2,300 contractors in nine countries. Its fortunes took off after the 2003 invasion of Iraq when it was employed by Paul Bremner, the US proconsul. It is now thought to have about 1,000 contractors in Iraq, as well as a fleet of helicopters.

In March 2004 four contractors were captured by a mob in Fallujah, mutilated and hung from a bridge. The US military responded with a full-scale assault on the town.

In April 2005 six contractors were killed when their helicopter was shot down near Tikrit. In May this year a Blackwater guard shot dead an Iraqi driver who drove too close to a convoy. The same month a convoy was ambushed in central Baghdad, triggering a battle in which the contractors and US troops, backed by Apache helicopters, opened fire in a crowded area.

A State Department spokesman refused to discuss how the suspension of Blackwater’s operation in Iraq might affect its security regime there. There was no immediate comment from Blackwater.

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