By Julia Edwards

WASHINGTON (Reuters) - U.S. Attorney General Eric Holder said on Friday the Justice Department would use its full authority to demand police reforms in Ferguson, Missouri, including possibly going so far as dismantling the department accused of racial bias.

"We are prepared to use all the power that we have ... to ensure that the situation changes there," Holder told reporters.

Asked if that included dismantling the Ferguson Police Department, Holder said, "If that's what's necessary, we're prepared to do that."

Civil rights lawyers have previously said the county could absorb the functions of the Ferguson Police Department.

The Justice Department issued a report this week that found that police in Ferguson overwhelmingly arrested and issued traffic citations to black residents, creating a "toxic" environment with its policing practices.

That culture of distrust erupted in August, when white Ferguson Officer Darren Wilson fatally shot 18-year-old Michael Brown, who was black and unarmed. The incident triggered months of protest and a national debate about race and police behavior.

Holder also said President Barack Obama's task force on policing will issue guidelines to address jailing citizens who owe money to the city, a practice used in Ferguson. But he noted that the federal government does not have the authority to demand such a change of local governments.

Ferguson city officials will meet with the Justice Department in about two weeks to begin negotiating an agreement on reforms, Ferguson Mayor James Knowles said.

If the two parties cannot reach a consensus, the Justice Department can sue and force reform.

Knowles said on Friday that the city would not settle with the Justice Department if the negotiations do not lead to "mutual satisfaction."

"There are a lot of things in that report that are very troubling and need to be addressed, but there are also things that are an overreach," Knowles said.

(Reporting by Julia Edwards; Additional reporting by Carey Gillam in Kansas City; Writing by Emily Stephenson; Editing by Sandra Maler and Lisa Shumaker)