There are conflicting reports of how the deaths in al-Mahmudiya occurred, with ministry sources saying a car bomb had exploded in the town, 30km south of the Iraqi capital.
But police sources say they were hit by a series of explosions followed by an attack by gunmen through the market - an unusual tactic in Iraq against civilians.
Al-Mahmudiya has been a flashpoint of Sunni-Shia tension and has suffered frequent bombings and shootings.
The town centre has a mostly Shia population, with Sunnis living in outlying areas and surrounding villages.
The raid appears to be part of the growing campaign of tit-for-tat sectarian killings which have overtaken the Sunni-led insurgency as the biggest security threat in Iraq.
It was one of the worst attacks in the country in recent months and came on the anniversary of the coup that brought Saddam Hussein's Baath party to power in 1968.
On Sundday, a suicide bomber killed at least 20 people in a cafe outside the capital, and the head of the country's North Oil Company was kidnapped in Baghdad.
Aljazeera channel reported that t
he cafe was close to a Shia mosque in an area populated by Turkmen Shia, and that rescuers were searching through the rubble for survivors.
The blast took place in the town of Tuz Khurmatu, 170km north of Baghdad, Colonel Abbas Mohammed told Reuters.
Gunmen seized Adel Qazaz from his car in northern Baghdad, even as Iraqi police continued to search for the chief of the national Olympic Committee, Ahmed al-Hadjiya, who was abducted from a meeting along with 30 others a day earlier.
In southern Iraq, the British Army has arrested a leader of the Shia Mahdi Army for orchestrating violence and unrest in the Basra region.
The man, Sajad Abu Aya, was arrested on Monday in an operation involving helicopters and hundreds of troops.
Major Charlie Burbridge, an army spokesman, said: "We got the man we wanted."
One British soldier was killed and another wounded in the raid.
The arrested man was "strongly suspected of involvement in planning and directing terrorist attacks on civilians in Basra, executions, and attacks on coalition forces", Burbridge said.