* Local leader arrested on terrorism charges

* Sunni fighters capture five Iraqi soldiers

(Adds Sunni fighters capture Iraqi soldiers)

By Waleed Ibrahim

BAGHDAD, March 28 (Reuters) - Three people were killed in hours of clashes between Iraqi security forces and Sunni Arab neighbourhood guards in Baghdad on Saturday, and the guards captured five soldiers, medical and security sources said.

At least 15 people were wounded in the clashes.

Baghdad security spokesman Qassim al-Moussawi said the firefight with the guards, who have been sponsored by the U.S. military to fight al Qaeda, started after Iraqi forces arrested their leader, Adil al-Mashhadani, and at least one of his men, on terrorism charges in the central district of al-Fadhil.

"They had a judicial warrant," Moussawi said, adding that seven Iraqi soldiers had been wounded in the clashes.

A local hospital source said he had received three bodies -- two civilians and a policeman -- and treated eight civilians.

A Reuters reporter heard heavy gunfire near the scene and saw Iraqi army snipers on roofs all around the neighbourhood. He said Iraqi forces had ringed the area but the streets were largely controlled by the Sunni Arab fighters.

A police source said they had also captured five Iraqi soldiers in the area's narrow alleyways during the clashes.

"One of them is an officer. Negotiations are now going on between the military forces and the Majalis al-Sahwa," the source said, referring to Arabic name for "Awakening Councils", the units led mostly by Sunni Arab sheikhs and including many former insurgents who rose up against al Qaeda in 2006.

They have been credited with drastically cutting violence after they switched sides, routing the Sunni Islamist group from parts of Baghdad, western Anbar province and some northern towns. But deep mistrust remains between them and Iraq's Shi'ite-led government.

How the government handles the guards it once fought is seen as a major test of reconciliation as the United States prepares to pull combat troops out by Aug. 31, 2010.

"What happened to Mashhadani was just revenge. Now it is obvious to us that the government is insincere in its talk of reconciliation," said a guard who witnessed the battle.

The guard declined to be named, saying: "After this, we can't trust anyone anymore."

An Iraqi interior ministry source said U.S. forces were on the parameter of the area for back-up. The U.S. military did not immediately respond to requests for confirmation of this.

There are just under 100,000 members of the Awakening Councils nationwide. The U.S. military has paid them but last year the Iraqi government started taking over the programme.

The government will soon pay all of them itself, until it absorbs 20 percent into its own security services and finds civilian jobs for the rest.

Many former insurgents in the programme have feared being arrested or pursued in sectarian vendettas, despite assurances by Prime Minister Nuri al-Maliki that this would not happen.

U.S. officials have said a dangerous situation could arise if Maliki's government fails to bring about reconciliation with these Sunni Arab fighters but say Iraq has the right to detain those accused of grave charges, such as murder or terrorism. (Writing by Tim Cocks; Editing by Jon Boyle)

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