The announcement on Saturday spells the end of a tentative ceasefire in Najaf after more than a week of clashes that have stirred anger across the region.
"The Iraqi interim government is resuming military clearing operations to ... establish law and order in the holy city," said National Security Adviser Muwafaq al-Rubaai on Saturday.
He said the government had made every effort to find a peaceful solution to 10 days of conflict that had killed hundreds.
But a close aide of al-Sadr, Shaikh Ali al-Sumaisim told Aljazeera that interim Prime Minister Iyad Allawi was to blame for the collapse of talks.
"We accepted all the points raised by al-Rubaai," said al-Sumaisim. "But ... just as we were about to sign the agreement, interim Premier Iyad Allawi contacted him, put an end to the talks and referred the whole issue back to Baghdad."
"Just as we were about to sign the agreement, interim Premier Iyad Allawi ... put an end to the talks"
Shaikh Ali al-Sumaisim,
aide to Muqtada al-Sadr
Al-Sadr, who has periodically sought an accommodation with the US-installed authorities ruling Iraq, has been demanding the withdrawal of foreign forces and an amnesty for his fighters.
Al-Sadr's al-Mahdi army has posed the biggest challenge to Allawi's government since the US occupation authority gave it official but in effect limited sovereignty on 28 June.
Al-Sadr supporters protest
against US-led attacks on Najaf
But US and Iraqi government forces face a dilemma in trying to oust the al-Mahdi army from Najaf, which is home to several revered Muslim sites, including the Imam Ali mosque and shrine.
The week-long offensive there caused outrage throughout Iraq and much of the Arab world as protesters took to the streets and voiced anger at the attacks by US-led occupation forces.
"Presently, the US forces are making a pincer movement towards Najaf," said al-Sumaisim.
"This is an explicit conspiracy to commit a large-scale massacre in Iraq. The target is not only al-Sadr movement but also all the honest people of Iraq ... everyone who opposes the occupation and colonialism."