The move fulfills a campaign promise by Prime Minister Kevin Rudd, who was swept into office in November largely on the promise that he would bring home the country's 550 combat troops by the middle of 2008. Rudd has said the Iraq deployment made Australia more of a target for terrorism.
Defense Minister Joel Fitzgibbon told a news conference that Australia's military was overstretched with commitments in East Timor, Afghanistan and Iraq.
"It's the right time to bring out troops home," he said. "Indeed, the time to bring them home has passed."
The head of Australia's defense force, Air Chief Marshal Angus Houston, said Iraqis had taken over security where the Australians were based.
"I think the conditions are right for us to pull out. The operational overwatch mission is complete and the Iraqis are handling business in the province," Houston said.
But Rudd's predecessor, former Prime Minister John Howard, said he was "baffled" by the decision to withdraw the troops.
"If I had been returned at the last election we would not have been bringing (troops) home, we would have been looking at transitioning them from their soon-to-be terminated role to a training role," Howard told the Sydney Morning Herald in an interview published Monday.
Howard, who led the country for 11 years and celebrated his friendship with President Bush, told the newspaper that the decision to send Australian troops to Iraq in 2003 was "very, very, very hard." But he stood by his choice, which he said helped further deepen Australia's alliance with the United States.
Australian troops helped train 33,000 Iraqi army soldiers following the overthrow of Saddam Hussein. They helped train the Iraqis in logistics management, combat service support and counterinsurgency operations.
About 300 troops will remain inside Iraq for logistical and air surveillance duties, as well as guarding Australian diplomats and others in Baghdad.
A further 500 soldiers will remain in the region, including 200 sailors aboard the frigate HMAS Stuart in the Persian Gulf. Australia also will leave behind two maritime surveillance aircraft.
Opposition leader Brendan Nelson, of the Liberal party, backed the withdrawal of troops but said he would prefer that some trainers stay behind, to continuing helping "the Iraqis to look after their own security."
But another Liberal party politician said the job is not yet done in Iraq.
"I mean, you have a war that is essentially being won and we're being seen to move out of there," Dennis Jensen told reporters. "We really should have stayed the entire course."
The soldiers, as well as 65 army trainers, were stationed at Talil, about 185 miles south of Baghdad, and were responsible for providing security training for Iraqi forces, as well as reconstruction and aid work.
They have been on standby to offer backup to Iraqi forces in the south for the past two years. They were never officially called out to act in that role but maintained a policy of active patrolling.
Six Australian soldiers were wounded in Iraq.
Rudd remains committed to keeping Australia's 1,000 troops in Afghanistan.