The report was released on Friday, the same day three bombers attacked an important Shia mosque in Baghdad, killing at least 70 people and wounding 158 more as they were leaving at the end of Friday prayers.
The bombing was a stark reminder of the volatile sectarian tensions in the country amid deadlocked political talks to form a government capable of uniting the country.
But the State Department report maintained progress has been made on the political front despite the upsurge in sectarian violence since the February 22 bombing of the Golden mosque in Samarra.
It said that despite setbacks due to the violence and a highly polarised political landscape, Sunni leaders were re-engaging with Shia and Kurdish leaders across party lines.
It highlighted calls by Iraqi political leaders for unity in the wake of the Samarra bombing, and noted the pressure exerted by Zalmay Khalilzad, the US ambassador, and American leaders for the prompt formation of a unity government.
The report said: "These efforts are continuous and ongoing. We expect to see rapid and substantial results in the government formation process in the near future."
"We expect to see rapid and substantial results in the government formation process in the near future"
US State Department
Despite soaring reconstruction costs due to violence, the report said the Iraqi economy had made "measurable progress", growing from $18.9 billion in 2002 to $33.1 billion in 2005.
The report put the number of Iraqi security forces at 240,000.
But it said reductions to the 132,000-strong US force in Iraq would depend on "conditions on the ground", not on how many Iraqi forces had been trained and equipped.
"There is no specific threshold for the number of IPS (Iraqi police) that must be trained and equipped to maintain law and order and thereby enable US force levels to be reduced."