The Iraqi interior ministry said the contractor, based in North Carolina, was now banned from operating in Iraq.
The Blackwater workers, who were contracted by the US state department, apparently opened fire after coming under attack in Baghdad on Sunday.
Thousands of private security guards are employed in lawless Iraq.
They are often heavily armed, but critics say some are not properly trained and are not accountable except to their employers.
The interior ministry's director of operations, Maj Gen Abdul Karim Khalaf, said authorities would prosecute any foreign contractors found to have used excessive force.
"We have opened a criminal investigation against the group who committed the crime," he told the Agence France-Presse news agency.
All Blackwater personnel have been told to leave Iraq immediately, with the exception of the men involved in the incident on Sunday.
They will have to remain the country and stand trial, the ministry said.
The convoy carrying officials from the US state department came under attack at about 1230 local time on Sunday as it passed through Nisoor Square in the predominantly Sunni neighbourhood of Mansour.Read More
The Iraqi interior ministry has cancelled the operating licence of a US security firm after it was involved in a shootout that killed eight people, a senior official said. Abdul-Karim Khalaf, a ministry spokesman, said 13 people were wounded when Blackwater USA staff opened fire in a Baghdad incident involving an attack on a US motorcade. "The interior minister has issued an order to cancel Blackwater's licence and the company is prohibited from operating anywhere in Iraq," Khalaf said on Monday. "We have opened a criminal investigation against the group who committed the crime." The spokesman said witness reports pointed to Blackwater involvement but said the incident, in a predominantly Sunni area of western Baghdad on Sunday, was still under investigation. US troops are immune from prosecution in Iraq under the UN resolution that authorises their presence, but Khalaf said the exemption did not apply to private security companies. 'Crime' committed Blackwater, based in North Carolina, provides security for many US civilian operations in the country. Read More
Employees of the company are alleged to have opened fire indiscriminately after a bomb exploded on Sunday in the Mansour district of the city, packed with people shopping for Ramadan.
The Iraqi government's decision, personally endorsed by the Prime Minister Nouri al-Maliki, is the strongest measure taken yet against private security contractors, who have been repeatedly accused of carrying out unprovoked shootings of Iraqi civilians.
Yesterday, in an extraordinary telephone news conference, the US embassy spokeswoman could not answer whether the company was still working for the Americans inside the Green Zone, or what its legal position was along with similar foreign contractors within Iraq.
The shooting started after a car bomb blast killed two soldiers and lasted for more than 20 minutes, with civilians seeking safety in stores and behind cars. Afterwards the Blackwater convoy roared away from the scene, shoving cars out of their way with their armoured four-wheel-drive sports utility vehicles (SUVs).
Initially, the US embassy said the contractors, who were providing security for State Department officials at a meeting, had reacted after coming under small arms fire. Later, however, it said they had "reacted to the bombing".
The Independent, which was present in Mansour at the time of the bombing and shooting, spoke to Iraqis caught up in the incident who described foreigners dressed in civilian uniforms opening fire without warning from their vehicles at cars and people in the street.Read More