The fight is rooted in an old and deep animosity between the two countries that lingers even though Saddam was overthrown seven years ago and a democratically elected, US-backed government is now in place.
Kuwait's national airline, Kuwait Airways, has long demanded $1.2 billion in reparations from Iraqi Airways for the alleged theft of 10 airplanes and millions of dollars worth of spare parts during the invasion. It has sought to freeze the Iraqi company's assets worldwide.
Iraq says the demand is unjust and it should not be held accountable for actions of Saddam's "illegal" regime.
While Iraq has one of the largest debts of any country in the world, Kuwait just announced a $28 billion dollar budget surplus for the last fiscal year that far exceeded its own forecasts.
But Kuwait maintains Iraq should pay for its past mistakes and learn not to repeat them.
Christopher Gooding, a lawyer representing Kuwait Airways, called Iraq's strategy a "cynical tactic" and said it will not end the dispute because Kuwait will still hold the government accountable for the debt.
"It appears to me to be a sorry reflection of Iraq's attitude to its international commitments that liquidating its own national airline is seen as preferable to addressing those commitments," he said in an e-mailed statement to The Associated Press.
"This action will not protect a government company because when a government company is declared bankrupt, its assets are transferred to the Ministry of Finance, and therefore the ministry will be prosecuted," he added.
After Saddam's ouster, the UN decided Iraq should pay more than $52 billion in compensation for individuals, companies and organizations that incurred losses in the war that followed Saddam's invasion of Kuwait. Most of that was for Kuwaitis. Iraq paid $27 billion from oil revenues, but still owes Kuwait about $25 billion.
Iraq is seeking cancellation of the debt. And Kuwait has resisted pressure from Washington to forgive $15 billion of it.
"There is a huge amount of bitterness that still exists.
It really goes both ways," said David Bender, a Middle East analyst at the Eurasia Group in Washington.
He said the international community has heeded US pleas to forgive a large chunk of Iraq's Saddam-era debt, with the exception of Kuwait and Saudi Arabia, which have been very resistant.
"Saudi Arabia and Kuwait have tremendous fears of an Iranian-dominated Iraq that becomes an oil power and economic power and, in theory, a political power in the region," he said. "Despite significant US pressure on Saudi and Kuwait to improve their relations with Iraq, they have been largely resistant to that." The Iraqis stripped billions of dollars worth of Kuwaiti infrastructure and private property until they were driven out by a US-led coalition in 1991. They set fire to Kuwaiti oil fields as they retreated, darkening the skies over Kuwait for months. The Kuwaitis spent $1.5 billion to extinguish the fires.
Iraqi government spokesman Ali Al-Dabbagh said the Cabinet had to liquidate the airline to put an end to the Kuwaiti dispute. The government declared the airline bankrupt and decided to dismantle it on Tuesday.
"Iraq's Cabinet decided to close Iraqi Airways and announced its bankruptcy because the company doesn't own any airplanes and because of the Kuwaiti government's cases raised against the company," Transportation Ministry spokesman Karim Al-Tamimi told the AP.
The ministry said the company will continue to operate until it is fully liquidated, but it is not known how long.
Under Iraqi law, the process of liquidating assets can take no more than three years, the ministry said. The airline's assets make up about 10 percent of what Kuwait is demanding, said the ministry.
Al-Tamimi said the airline does not own any planes and the government hopes to replace it with two or three new companies.
Iraqi Airways charters planes from other companies to fly to Lebanon, Iran, Dubai, Egypt, Syria, Turkey, Greece and Jordan.
On Tuesday, the airline canceled routes to Britain and Sweden after Kuwait tried last month to confiscate its first plane to fly to London in 20 years.
