The withdrawal of the Fadhila (Virtue) party on Friday, part of the predominantly Shia United Alliance bloc, may help to end a struggle over the important post of oil minister.
A spokesman said the party was withdrawing because it felt the selection of ministers was being dictated by personal interests, not national unity.
"We will not return to the negotiating table, and we have announced our final position. We withdraw from the formation of the government, and we will stay in parliament to express the voice of the people," Sabah al-Saadi, a party spokesman, said on Friday.
"We have found that the way the negotiations are progressing and the way ministerial posts are being distributed, which is based on personal interest and selfish desires, will not lead to the formation of a truly new Iraq," al-Saadi said.
The party had been pushing its own candidates against Hussain al-Shahristani, the choice of bigger Alliance groups and who is an independent member of the Alliance.
Sunni cleric killed
An armed man shot dead a senior Sunni cleric on Friday, the second prominent Sunni cleric killed in as many days in the mainly Shia southern Basra region, a Sunni religious official said.
Khalil Jaber was killed after leaving a mosque following on Friday prayers, Shaker Mahmoud of the Sunni Endowment said.
Security outside a Shia mosque
testifies to sectarian tensions
Jaber had just finished leading the weekly noon prayers at the al-Adhary mosque in central Basra, 550km south of Baghdad, when a man walked up to him in the market square and shot him. The man then fled.
Police had no immediate comment.
A cleric and two aides were killed on Wednesday evening in the nearby town of Zubair.
Also on Friday, a car bomb exploded outside a local office of the Iraqi prime minister's Dawa party in a Baghdad suburb. No one was hurt.
The row over the oil ministry, in control of the world's third biggest reserves of crude and at the heart of efforts to revive Iraq's shattered economy, has been a major reason for a delay in efforts to form a government in recent days.
Al-Saadi also criticised other parties for trying to force candidates for ministries on the United Alliance's prime minister-designate, Nuri al-Maliki.
Al-Maliki has another 10 days under a one-month constitutional deadline to present his cabinet to parliament.
Al-Hashemi is the Fadhila party's
candidate for oil minister's post
Al-Saadi said much of the current negotiations were being influenced by external pressure from the US ambassador in Iraq, Zalmay Khalilzad.
Khalilzad has played a major role in mediating in Iraq's political disputes for the past year.
He has said that Washington, frustrated by the delay in forming a government after December's election, wants competent ministers appointed to run Iraq for the next four years as it tries to reduce the US presence.
There is also a lack of agreement on filling the sensitive ministries of interior and defence with figures free of ties to militias that have flourished in post-Saddam Hussein Iraq.
Leaders from the Sunni minority - and, more discreetly, the US - are demanding the removal of the interior minister, accused of allowing Shia police death squads to operate.
Fadhila is one of more than a dozen parties in the United Alliance that has a near majority in parliament and has a representative on the bloc's seven-strong steering committee.
It had been pressing to have a Fadhila member named oil minister. Among its candidates was the present minister, Hashem al-Hashemi.