Shooting broke out when an advance party of the interim interior minister's security detail came upon a civilian vehicle whose occupants they felt were behaving suspiciously, the source said.
It is not clear who fired first, but the Iraqi driver of the vehicle and one of minister Falah al-Naqib's guards were killed and another bodyguard wounded.
The minister was in a vehicle some distance from the shooting and was unhurt.
The two men in the civilian vehicle, at least one and possibly both of whom were British, were disarmed and arrested but soon released, the source said.
A passport shown to reporters at the scene belonged to a British man who had a security pass for the US embassy in Baghdad.
Witnesses at the scene, where a Korean-made compact sedan stood covered in bullet holes, said a female Iraqi bystander also appeared to have been killed. Police could not confirm this.
The identities and occupations of the two men have not been released.