Iraq has said it will dissolve state-owned Iraqi Airways over the next three years and pursue private options to avoid asset claims made by Kuwait over their 1990-91 war.
Wednesday's move came a day after the airline halted flights to Britain and Sweden under threat that its planes would be seized by Kuwait in a row over war reparations.
Amer Abdul-Jabbar, Iraq's transport minister, said the cabinet had decided on Tuesday to dissolve the company, but that the process could take three years.
"Iraqi Airways will not stop in its work, and its employees will continue working," he told Reuters news agency.
"We have the idea of establishing other private companies -- there are three being established," Abdul-Jabbar said.
Iraq and Kuwait have been locked in a long-running dispute over billions of dollars in reparations from Iraq, including some $1.2bn related to aircraft and parts seized
during the invasion of Kuwait by Saddam Hussein, the former Iraqi ruler in 1990.
A lawyer for Kuwait Airways called the Iraqi government's strategy a "cynical tactic'', pointing out that the move would not end the dispute because Kuwait would still hold the government accountable for the debt.
"This action will not protect a government company, because when a government company is declared bankrupt, its assets are transferred to the Ministry of Finance, and therefore the ministry will be prosecuted," Christopher Gooding said.
Last month Iraqi Airways made its first commercial flight to London in 20 years, however, a lawyer for the Kuwaiti authorities tried to seize the plane on arrival.
The director-general of Iraqi Airways had his passport seized by the British high court, which ruled that the airline must declare its assets. He was later allowed to leave Britain.
Iraq has said it cannot sustain its reparations payments to Kuwait for the invasion, which it claims are the highest paid by any country in history.
Al Jazeera's Zeina Khodr, reporting from Baghdad, said that Iraq had been making reparation payments for some time.
"For years Iraq has had to pay 5 per cent of its oil income into a special UN fund. The government would like the government of Kuwait to write off the debt and forgive the past," she said.