Iraqi troops backed by U.S. forces battled gunmen in Baghdad's Sadr City on Sunday, a return to heavy fighting in the capital after Shi'ite cleric Moqtada al-Sadr pulled his militiamen off the streets a week ago.

Hospital sources said at least 25 Iraqis were killed in the clashes and 98 wounded.

Rocket or mortar attacks killed three U.S. soldiers and wounded 31 of them in Baghdad, among the biggest tolls of injured troops faced by the Americans in months. That included two U.S. soldiers killed and 17 wounded in a strike on the fortified Green Zone government and diplomatic compound.

A fourth U.S. soldier was killed by a roadside bomb in Diyala province to the north and a fifth died in an attack in eastern Baghdad in which the military gave no further details.

The fighting follows a week of relative calm after a crackdown by Prime Minister Nuri al-Maliki on Sadr followers led to battles across the capital and the south late last month.

Iraqi soldiers were moving through two southern sectors of Sadr City, a Shi'ite slum of 2 million people and stronghold of Sadr's Mehdi Army militia, said U.S. military spokesman Lieutenant-Colonel Steven Stover. U.S. helicopters fired at least two Hellfire missiles, killing nine fighters, he added.

The unrest comes two days before U.S. Ambassador Ryan Crocker and U.S. commander General David Petraeus are due to deliver key testimony to the U.S. Congress on progress in Iraq.

Police said the joint U.S.-Iraqi military operation began early on Sunday. Gunfire could be heard throughout the day.

Lieutenant-General Abboud Qanbar, head of the Iraqi military in Baghdad, said all armed groups must hand in their weapons.

"If they refuse to surrender their arms, we will confiscate them," Qanbar told reporters at a police station in Sadr City.

Mehdi Army fighters bristled at the raids. "I have lost my cousin in these clashes today. I think Maliki will be happy now," a Mehdi Army street commander giving his name as Abu Ammar told Reuters.

U.S. Apache helicopter gunships swooped overhead and a column of black smoke towered over the Jamila market, a vast bazaar on the edge of the slum that supplies wholesale food for much of the eastern half of the capital.

"Criminals fired rockets and they hit the Jamila market. I don't know how many people they killed," Stover said. Police said a fire at the market destroyed 100 shops, blazing unchecked for hours because firefighters could not reach it.

BLOCKADE

U.S. and Iraqi forces have imposed a blockade on vehicle traffic in and out of Sadr City for two weeks. Residents of the besieged district describe skyrocketing food prices, rubbish piling up and claustrophobia from being trapped indoors.

"We haven't been able to sleep since this fighting started two weeks ago," said Wardan Ali, a student from Sadr City who walked 10 km (6 miles) to university because of the blockade.

Sadr's bloc in parliament denounced the raids.

"The intervention of U.S forces is horrible and unjustified. Some people in Sadr City believe these forces will hunt and kill them," said Hassan Hashem, a Sadrist member of parliament's security committee.

The fighting in Sadr City followed a joint call by Iraq's main factions, apart from the Sadrists, for all militias to hand over weapons, an apparent attempt to isolate Sadr.

Sadr has called for 1 million Iraqis to march against U.S. "occupiers" on Wednesday, when Crocker and Petraeus are due to conclude two days of testimony before the U.S. Congress.

The two top U.S. officials in Iraqi are expected to call for a pause in American troop withdrawals after 20,000 U.S. soldiers return home over the next four months.

Near the northern city of Mosul, at least 40 students on a bus were kidnapped by gunmen for several hours before Iraqi security forces freed them, said Brigadier-General Khalid Abdul-Sattar, security spokesman for Nineveh province.

The incident was a reminder of continuing unrest in Iraq's northern mixed and Sunni Arab areas at a time when attention is focused on violence in Shi'ite areas in Baghdad and the south.

"These are terrorist groups linked to al Qaeda and Saddam's former regime who are terrorising innocent people constantly," government spokesman Ali al-Dabbagh told Al Arabiya television.

Sunni Islamist al Qaeda has regrouped in northern provinces after being pushed out of western Anbar province and Baghdad.