The Libyan foreign ministry said the decision was taken due to the action taken by the United States and the British occupation forces against diplomatic missions in Baghdad.
The US-led forces are responsible for the safe return of the Libyan diplomats and the protection of their embassy, it stressed.
The break in ties "will have no bearing on the relations between the two peoples, Iraqi and Libyan", the ministry said. Relations would be restored "once Iraq recovers its freedom, independence and sovereignty", it added.
Reaction to raid
The Libyan announcement comes close after the US raid on the Palestinian mission in the Iraqi capital.
US forces ransacked the Palestinian mission on Tuesday, arresting at least eight people, including seven Palestinians and a Syrian. US commander, Lieutenant General David McKiernan, could not say if any of them were diplomats.
But a spokesman for the Palestinian mission said three of them were accredited to the Iraqi foreign ministry.
The US state department on Thursday said foreign diplomats in Iraq no longer enjoyed diplomatic immunity or any of the privileges they were accorded under their accreditation to Saddam Hussein's government.
In addition, Washington advised foreign countries to hold off on sending envoys to Baghdad until a new Iraqi government was in place, as "at this point there is really no purpose" for them to be there.