Australian soldiers mistakenly opened fire on bodyguards of the Iraqi trade minister in Baghdad, killing one and wounding three, the Australian defence force confirmed on Thursday.

"The security detachment was conducting routine security duties when this incident occurred," said Vice Chief of the Australian Defence Force (ADF), Lieutenant General Ken Gillespie.

"The ADF deeply regrets the injuries and loss of life that has occurred. As with all ADF incidents of this nature the matter will be formally and fully investigated," Gillespie said in a statement.

The shooting took place on Wednesday as an Australian trade delegation left the offices of Trade Minister Abdul Falah al-Sudany in the capital's western Mansour district.

Salim al-Bahadiry, a bodyguard for the trade minister, told Reuters at the scene that the Australian convoy left the ministry and an Iraqi convoy followed. The Iraqis then tried to overtake the Australians.

The bodyguard said the Australians killed one Iraqi, wounded three guards and two civilians.

Iraqi police and Interior Ministry sources confirmed the shooting. They said it appeared the Australians had mistaken the bodyguards, who were dressed in civilian clothes and armed with AK-47 rifles, for insurgents.

The incident could potentially embarrass Canberra, which has been trying to improve trade ties with Iraq after Baghdad suspended dealings with Australia's monopoly wheat exporter AWB Ltd over a kickbacks scandal.

Iraq, one of the world's biggest wheat buyers, imports around 3 million tonnes of wheat a year to help feed a population of 27 million people.

A 2005 UN report alleged AWB was one of more than 2000 firms that had paid kickbacks worth US$1.8 ($2.94) billion to Saddam Hussein's government through the UN-managed "oil-for-food" account. If proven, AWB would have broken UN sanctions against Iraq.