Police said the blast was triggered at the entrance to a market in the old city, 150 metres from the Imam Ali mausoleum and close to the offices of Iraq's most revered Shiite cleric, Grand Ayatollah Ali al-Sistani.
The attack came as the health ministry said the Baghdad morgue had handled 1,850 corpses last month, most of them murder victims.
It was the latest in a series of bombings and shooting attacks that have poisoned relations between Iraq's majority Shiite community and the once-dominant minority Sunnis.
US generals warned last week that sectarian bloodshed could push Iraq into civil war, despite attempts by the country's unity government to restore order and promote a national reconciliation plan.
Imam Ali was both cousin and son-in-law to the Prophet Mohammed and Shiites regard him as the prophet's chosen successor to lead the Muslim world. He was murdered in the year 661.
His tomb in Najaf is a place of veneration and pilgrimage for Shiites, who form a minority among Muslims worldwide but are the largest religious community in Iraq and Iran.
Separately, a US spokesman announced that divers had recovered the bodies of two crewmen from an army Blackhawk helicopter, which ditched into a lake in Anbar province on Tuesday, injuring four more personnel.
Late Wednesday, the US military said three soldiers had been killed in combat, bringing its death toll in Iraq since the March 2003 invasion to 2,596, according to an AFP count based on Pentagon figures.