The potentially precedent-setting case could undercut fraud claims involving billions of dollars in reconstruction contracts that were issued by the U.S.-led Coalition Provisional Authority (CPA) and paid for with money belonging to the Iraqi people.

Arguments broke out in federal court Friday over two fundamental questions: whether the CPA, which ruled occupied Iraq, can be considered a U.S. agency, and whether fraud involving Iraqi money can be subject to suits under the False Claims Act, considered one of the federal government's most important tools against fraud.

John Boese, an attorney for the security company, Custer Battles, asked a judge to dismiss the case as ''fatally defective.'' Boese argued that the act didn't apply to his clients since the CPA, not the U.S. government, was the victim.

''The funds that were used were Iraqi funds, not U.S. funds,'' he said,

Custer Battles has denied any fraud was committed, attributing the allegations to disgruntled former employees who have since emerged as competitors to Custer Battles.

Those employees are now suing Custer Battles under the False Claims Act, which allows citizens to sue U.S. contractors on behalf of the federal government to seek damages for fraud.

Custer Battles was one of the first U.S. contractors on the ground in the chaotic days following the fall of Saddam Hussein last year. The company's two founders, Scott Custer and Mike Battles, were former special forces soldiers who opened for business with almost no money and little previous experience.

Nonetheless, the company won at least four contracts in Iraq worth millions of dollars, including a deal to provide security at Baghdad International Airport and another to help Iraqis swap their old currency for new dinars minted by the CPA.

Those contracts came under scrutiny after several former employees accused Custer Battles of creating a series of shell companies that were used to bilk the CPA out of millions of dollars. Company officials allegedly submitted false invoices and also billed for work done by other companies.