WASHINGTON - An internal State Department report says Blackwater Worldwide may lose its license to work in Iraq and recommends the agency prepare alternative ways to protect U.S. diplomats there.

The 42-page report by the State Department's inspector general says the department faces "numerous challenges" in dealing with the security situation in Iraq, including the prospect that Blackwater may be barred from the country. The department would then have to turn to other security arrangements to replace Blackwater, officials said.

The report is labeled "sensitive but unclassified."

An official familiar with the report said initially it would recommend that the department not renew Blackwater's contract when it expires next year. But that specific language is not in the document, a copy of which was obtained by the Associated Press. The official spoke on condition of anonymity because the report is not yet public.

The official said later that such a recommendation would not be made until completion of an investigation of the September 2007 incident in Baghdad's Nisoor Square in which Blackwater guards killed 17 Iraqis. Five guards have been indicted on manslaughter and other charges stemming from that incident. The company was not implicated.

The department had no immediate comment on the report. Deputy spokesman Robert Wood said officials were looking at "whether the continued use of Blackwater in Iraq is consistent with the U.S. government's goals and objectives."

It is not clear how the department would replace Blackwater. It relies heavily on private contractors to protect its diplomats in Iraq, as its own security service does not have the staffing or equipment to do so. The report suggests one way to fill the void would be for the department's Diplomatic Security Service to bolster its presence in Iraq.

Terminating the North Carolina-based company's Iraq contract would be difficult for Obama's secretary of state-designate, Hillary Rodham Clinton, because no other private security contractor has its range of resources, particularly its fleet of helicopters and planes.

Secretary of State Condoleezza Rice ordered a review of the department's use of private security companies after the Nisoor Square shooting. The inspector general's report is an analysis of how recommendations in that review have been put into place and includes several important findings, including that the department plan for the possibility that it may no longer be able to rely on private contractors such as Blackwater.

Blackwater spokeswoman Anne Tyrrell declined comment, saying the company had not seen the report. The company has said in the past it plans to largely get out of security contracting to concentrate on training and other projects.