Locals said the blast destroyed a police post and tore the front of a hotel in the Iraqi capital's upmarket Karrada district, setting fire to cars nearby.
"There are at least three dead," a local police official said.
The police said an ambulance packed with explosives drove up to the Shahine hotel at high speed and detonated.
"According to testimonies we received, an ambulance arrived very quickly in front of the hotel," Lieutenant Husayn Ali, the chief of police patrols in Karrada said.
The hotel is frequented by foreign business people. A police outpost on the other side of the road also bore the brunt of the blast.
Black smoke was seen pouring from the hotel as dazed guests emptied onto the street in their pyjamas.
The early morning blast is the latest in a series of deadly explosions that has rocked Baghdad recently.
At least 24 Iraqis were killed when a car bomb exploded on 18 January outside the US-led occupation force's headquarters in the capital.
Another car bomb blast on New Year's Eve outside a restaurant left eight dead.