The bomber blew the car up next to a line of recruits waiting at a health centre to take an eye test so they could join the Iraqi police in the town of al-Hilla, 100km south of the capital, witnesses said.
Many of those killed were at the market across the road, and were caught in the blast as they shopped.
"I was standing in the queue when I saw this Mitsubishi coming slowly towards us," Amir Hasan, one of the recruits, said at a nearby clinic.
"Then it blew up in a huge fireball. When I opened my eyes again, I was in hospital."
Television footage showed a pile of bloodied bodies outside the building.
Smoke rose from the wreckage of burnt-out market stalls as bystanders loaded mangled corpses on to wooden carts.
Others, their limbs ripped to shreds, were piled into the back of pick-up trucks. Nearby buildings were pockmarked by shrapnel.
Police recruits are constantly
targeted by anti-US fighters
People wept, clutched their heads in despair and shouted "God is Great" as rescuers led the injured away.
"The suicide bomber came from a nearby alleyway," said Zaid Shamran.
"There were two people in [the car] and when it stopped one man got out, shook hands and kissed the other man." Moments later the car exploded, he said.
An official in al-Hilla's health directorate said the latest toll was 125. US forces confirmed at least 110 dead.
Police recruits targeted
group purporting to be "al-Qaida in Iraq" claimed responsibility
for the attack in a statement posted on an Islamic website.
The statement said that "a cavalry of the Martyrdom Brigade pounced
on a column of the forces of the cross as they left their camp of Saqr" southwest of Baghdad.
The claim could not be independently verified.
The toll in al-Hilla's attack is the highest from a single attack since the fall of Saddam in April 2003.
In March 2003, more than 170 people were killed and hundreds wounded in a series of bombings in Baghdad and Karbala, just west of al-Hilla.
"I was standing in the queue when I saw this Mitsubishi coming slowly towards us. Then it blew up in a huge fireball. When I opened my eyes again, I was in hospital"
Witness Amir Hasan
Anti-US fighters have often targeted police recruits in their fight to drive US troops out of Iraq.
They have also attacked soldiers and other employees of the US-backed interim government.
The carnage comes as interim Prime Minister Iyad Allawi acknowledged Iraq's security forces were still unable to take on anti-US fighters without the help of US-led troops.
US soldier killed
"Iraqis should be able to start taking over more and more security responsibilities very soon," he wrote in the Wall Street Journal. "But we will continue to need and to seek assistance for some time to come."
Elsewhere in Iraq, another bomber blew up his vehicle in the town of Musayyib, just 30km from al-Hilla, but succeeded only in killing himself.
A hospital official said one civilian was killed and two wounded in fighting in Baquba, northeast of Baghdad.
Two policemen were killed in the capital, one by an anti-US fighter and the other by a roadside bomb, police sources and witnesses said.
The US military said one of its soldiers was shot and killed in Baghdad while manning a traffic checkpoint. The death takes the number of US troops killed in action in Iraq since the March 2003 invasion to 1498.