Australian Federal Police are investigating the shooting death of a 34-year-old security contractor at the Australian embassy in Baghdad.

In an incident that will raise significant questions about the security measures for diplomats and the Australian-founded private firm that guards the embassy workers, the former Australian soldier was shot dead early on Thursday morning.

A fellow Australian guard, believed to be a former special forces soldier, was taken to a military base at Baghdad Airport for questioning, sources in Iraq said.

Both worked for the Australian-founded Unity Resources Group, one of the leading security firms in the Middle East, which has faced accusations in recent months of corner-cutting, though the Australian government has vigorously denied those reports.