Despite their recent "surge" to boost security in Baghdad, US forces appear to have "simply pushed insurgent activity to neighbouring cities" and cannot create conditions that will resolve political differences among various groups.
The report said: "A political solution will require Sunni Arab representatives' participation in government, the recognition of radical Shia Muslim leader Moqtada al-Sadr as a legitimate political partner, and a positive response to Kurdish concerns.
"Within this warring society, the Iraqi government is only one among many 'state-like' actors, and is largely irrelevant in terms of ordering social, economic, and political life.
"It is now possible to argue that Iraq is on the verge of being a failed state which faces the distinct possibility of collapse and fragmentation."
The report said that although al-Qaeda in Iraq is challenged by local groups, there "is momentum behind its activity".
It said Iraq's neighbours - Iran, Saudi Arabia and Turkey - all "have different reasons for seeing the instability in Iraq continue, and each uses different methods to influence developments".