One soldier in the 9000-strong force under Polish command in central Iraq was killed in the fighting, according to Aljazeera's correspondent in the city.
Explosions were heard over different parts of the city as the rival forces traded fire for half an hour.
Witnesses and hospital staff said five civilians - four Iraqis and one Iranian - and five members of al-Sadr's Mahdi army were wounded in the clashes.
An AFP correspondent who witnessed the gun battle saw four wounded civilians and the charred remains of a four-wheel-drive vehicle of the occupation troops.
After the firing which erupted before Friday's prayers, the Mahdi army fighters said they had beaten back an assault by occupation forces.
East European troops are stationed
in the Shia holy city of Karbala
The occupation in a statement said at about 12:10 (0810 GMT), a convoy was attacked near the city hall. "The patrol returned fire," it said.
The statement said reinforcements from the division's 1st Brigade Combat Team were sent to secure the city hall and surrounding areas. The 1st BCT is made up of Polish, Bulgarian, Lithuanian and Latvian troops.
City hall is located near the office of al-Sadr religious foundation and al-Mukhayyam mosque controlled by his loyalists.
US-led occupation forces have threatened to retake Karbala, located 110km south of Baghdad, from al-Sadr loyalists who seized the city early this month.
An uneasy standoff had been in effect over the past few days, with Iraqi police hunkered down around official buildings and patrolling only near holy sites while al-Sadr's Mahdi militia was deployed near the cleric's local headquarters.
Meanwhile, al-Sadr said there would be martyrdom attacks if the occupation troops penetrated any of the Shia holy cities.
"If we are forced to defend our cities, we will resort to martyrdom operations and we will be human time bombs which would explode in their faces," he said in his weekly sermon at Kufa, on the outskirts of the holy city of Najaf, 160km south of Baghdad on Friday.
"We have enough weapons and a large number of followers"
"We have enough weapons and a large number of followers, and there are many believers who are ready to conduct martyrdom operations," he said.
"Until now we had refused to do this," he said, adding: "But if we are forced to do it, we will."
Al-Sadr also urged Najaf residents to create committees to run their city. "It is up to you to build your Islamic capital," he said.
"We should be united for one ultimate goal, to liberate our country and remove the filth from Iraq."
Occupation forces are attempting to capture al-Sadr in connection with the assassination of a rival Shia cleric.