The kingdom said the grisly videotape purporting to show the killings of the 12 men marked a "moment of national despair".
In Lele, 20 km south of the capital Kathmandu, a number of tearful villagers crowded around the humble home of Ramesh Khadka, 19, who was among those said to have been executed.
"We were expecting their safe return. This is very shocking. This is completely unexpected," said Sudarshan Khadka, Ramesh Khadka's brother.
"My brother went there just to earn a living. He had nothing to do with the Americans," said the 23-year-old.
Khadka's father Jit Bahadur Khadka wept hysterically upon hearing the report of his son's death from a representative of a labour agency, witnesses said.
A statement posted on a website was accompanied by pictures of what was claimed to be the bodies of the hostages. One of them was apparently beheaded while the rest appear to be shot.
A statement after an emergency cabinet meeting under Prime Minister Sher Bahadur Deuba did not indicate independent information on the hostages, saying the government learned of their fate from the news media.
"His Majesty's Government urges the international community to take strongest action against the perpetrators of this atrocity," the foreign ministry statement said.
"This barbarian act of terrorism to kill innocent civilians without asking for any conditions for their release is against the minimum behaviour of human civilisation," the statement said.
Nepalese officials had appealed on television networks and contacted diplomats and clerics in the Middle East in an attempt to negotiate the hostages' release.
PM Sher Bahadur Deuba called an
emergency cabinet meeting
The Kathmandu government has accused employment agencies of exploiting impoverished workers by putting them at risk in Iraq.
"His Majesty's Government also vows to take action against those persons who are found involved in illegal methods of recruitment of helpless Nepalese into Iraq, resulting into this devastating tragedy," the statement said.
Ramesh Khadka's father said earlier the family had taken a loan of more than 2000 dollars for his son's trip in the belief he would be a cook in Jordan.
The sum is a fortune in Nepal, one of the world's poorest countries.
The Jordanian employment agency Morning Star has said that the Nepalese headed to Iraq for work in the hope of earning more money.
Nepal declined US requests to contribute troops to Iraq, saying its army was busy fighting an insurgency which has wreaked havoc on the fragile economy.
The statement said the reported killings in Iraq were cause to halt internal conflicts.
"At this moment of national despair, His Majesty's Government appeals to the countrymen and women to show their patience for maintaining peace and harmony in the country," it said.
A young US citizen had recently distribuited fake videos and pictures of a beheading and made it look very convincing.
This raises questions on the authenticity of such web-based sources, given how simple it is to create and distribute it.
The killings have not been independently confirmed.