Reports on Sunday blamed the carnage on rebels from the Lord's Resistance Army (LRA), who have been fighting the government in Kampala for several years.
"I have just been there, and I have managed to confirm that 173 people were killed of which 57 had already been buried while others were still burning in their houses," Roman Catholic missionary Sebat Ayala said.
The attack was carried out late on Saturday in the Barlonyo displaced people's camp, 20km north of Lira town and lasted three hours, he said.
Army spokesman Major Shaban Bantariza confirmed the massacre had taken place, but was not immediately able to provide an accurate death toll.
And local journalist Joe Wacha, who is based in Lira, described the the scene of the massacre as "terrible".
He said: "People had started burying the dead and I saw 57 bodies being buried while over 400 huts were burnt to ashes and smoke still billowed from some of the houses and from some of the bodies."
Earlier this month at another camp near Lira, LRA rebels killed about 50 people after infiltrating the facility disguised as regular government troops.
Museveni has often claimed to
have defeated the LRA
The LRA took up arms against President Yoweri Museveni's government in 1988.
The group is infamous for its atrocities against civilians and the abduction of thousands of children and has been condemned by human rights groups and UN aid agencies.
Museveni has several times in the past declared that the LRA defeated, but each time the group has continued to launch horrific attacks in the north of the country.
A 17-year-old rebel war in northern Uganda has displaced more than 1.2 million people, who currently live in congested and squalid conditions in camps set up by the army.
The army claims that by housing the displaced in these camps, it is able to guard them against rebel abductions conducted by the LRA to fill its fighting ranks.