The vehicle belonged to the Tunisian embassy to Iraq whose driver had dropped off the ambassador at the Governing Council compound, which is a few hundred metres away.
The driver then parked the car and went to sit in the shade, said a policeman at the scene.
The driver said that he saw a car passing by and a passenger throwing something at the car before it blew up.
Another witness gave a similar account.
"A taxi drove past the car and a passenger threw out an explosive device. Shortly after that, I heard a big bang and then the car was on fire," said Akil Kadhim, a soft drinks seller.
There were no immediate reports of any injuries.
The incident occurred around 4:30 pm (1230 GMT), according to a US military spokesman.
US soldier killed
The blast came hours after a US soldier was killed in the Iraqi capital and at least nine wounded in resistance attacks around occupied Iraq.
The fatal encounter happened early on Monday in a multiple rocket-propelled grenade attack on their patrol in the capital, a US military spokesman said.
The attack occurred at around 2am GMT in the al-Mansur area of the capital, Corporal Todd Pruden told journalists.
Earlier, Specialist Nicole Thompson said the dead soldier was from the 3rd Infantry Division and confirmed that six members of the patrol were also wounded.
Another military spokesman, Giovanni Llorente, said a marine in southern Iraq died in a non-hostile incident, but would give no further details.
The fatalities bring the number of the dead of US personnel in Iraq to 80 since President Bush declared the war over on 1 May, according to the Arizona Republic newspaper.
Outside the capital
In a separate incident on a highway just north of the capital, a US convoy came under RPG attack.
One more death and nine
injuries for US soldiers
A US soldier at the scene told journalists one American soldier and two Iraqis had been wounded.
Eyewitnesses told Aljazeera’s correspondent in Ramada, west of Baghdad, they had seen at least two wounded American soldiers after a grenade attack in the al-Khalidiya district near the town.
The same witnesses claimed occupation forces arrived on the scene quickly to remove any evidence of the attack.
Other attacks were also heard around the town, but there are no details as yet.
Elsewhere on Monday, hand-picked council member Mohammad Bahr al-Uluum read out a statement marking the second session of the new US-appointed body.
He said the interim council’s priorities were to achieve security and stability, revive the economy and deliver public services.
His statement was seconded by Nasiir al-Jaadirji, who added that there was no contradiction in describing US forces as both liberators and occupiers.
Council member Abd ul-Aziz al-Hakiim denied the Shia majority would dominate proceedings, saying the council merely represented the make-up of the Iraqi people.