The army has agreed not to enter residential area for three days, while the Mahdi Army will withdraw its fighters. A militia commander arrested at the weekend will also be brought to court within 24 hours, town councillor Sheikh Ghanim Abid said.
Officials believe 81 people, including eight civilians, have died in Diwaniyah, 180 kilometres south of the capital, in clashes between security forces and militiamen.
Up to 61 bystanders were wounded in the 12 hour gun battle.
The US air force says that during the fighting an American F-16 jet dropped a 220kg satellite-guided bomb on an "enemy position" while flying in support of Iraqi and coalition troops.
Pipeline blast
A fire on a fuel pipeline in the same city killed 74 people. The blast, which officials believe was caused by looters seeking petrol, injuring another 94 people.
A Reuters reporter at the scene Diwaniya saw 15 charred and mutilated bodies, including that of a boy.
"Some of the wounded have burns in 75 per cent of their bodies," Hamid Jaafi, a health official in Diwaniya said.
Despite having the world's third largest reserves of oil, Iraq is gripped by a fuel crisis blamed on sabotage attacks, ageing infrastructure and rampart corruption. Prices for fuel have soared as the government phases out subsidies.
Army recruitment centre bombed
Police said insurgents killed at least 12 volunteers and wounded 38 more in a bomb attack on an army recruitment centre in the central Iraqi city of Hilla.
The bomb was hidden on a parked bicycle and was set off at around 8am as candidates gathered at the recruitment centre to sign up.
The recruitment centre in the south of the city was opened four days ago to encourage recruits from the mainly-Shiite areas around Samawa, Karabala and Najaf, the officer said on condition of anonymity.
Iraqi security forces are favourite target of insurgents who regularly bomb army and police recruitment centres to stop youngsters from joining the forces.
Two hours later, insurgents killed at least 24 people and wounded 35 more in a roadside bomb attack in a popular central Baghdad market.
Windows one kilometre away from the market were rattled by the blast.
Meanwhile, suspected Sunni Muslim insurgents killed two Shi'ite militiamen in an attack on the Mahdi Army office in Baquba, north of Baghdad.
Eight more civilians were shot in the same area which is known for its conflict between Sunni and Shi’ite gangs. Two blindfolded corpses were also discovered.
US soldier deaths
More than 30 Shi'ite families fled the village of Khan Bani Saad, south-west of the Baquba, after their homes came under mortar attack from suspected Sunni fighters.
Farther north, in the oil hub of Kirkuk, one policeman was killed when his patrol car was blasted by a roadside bomb, three other policemen and two bystanders were wounded in the blast.
Meanwhile, the US military has announced the death of five soldiers. The latest was killed southwest of Baghdad when his vehicle was hit by a roadside bomb.
The announcement brings the number of US troops that have died over the past three days to thirteen.