(FORTUNE Magazine) – In many ways it was a textbook example of urban warfare. In April a group of well-armed Shia militia in the Iraqi city of Najaf attempted to storm the local Coalition Provisional Authority offices. The badly outnumbered defenders repulsed the attack during a 23-hour firefight, shooting off thousands of rounds of ammunition. When bullets ran low, they called in helicopters to drop off fresh supplies and ferry out the wounded. But in a critical way the battle in Najaf represents the new face of modern warfare: Most of the defenders were not soldiers but civilian contractors--employees of Blackwater USA, a private security firm based in North Carolina. The guns, the ammo, and even the choppers all belonged to Blackwater.

A few days earlier another group of Blackwater employees had been ambushed in Fallujah; four were killed, and their bodies mutilated. Scenes of the carnage, broadcast around the world, sparked outrage and caused some to question whether America's efforts to rebuild Iraq were in vain. It is a question a lot of companies involved in the reconstruction effort have been asking lately.

There are as many as 20,000 private military contractors like those from Blackwater in Iraq, which is more than the number of actual soldiers from any of America's allies serving in Iraq, including Britain. A lot of those hired guns are ex-commandos: highly trained, heavily armed, and accustomed to operating in a war zone. The same can't be said for civilian contractors who drive trucks, repair power lines, and consult to the Iraqi government. Of the tens of thousands of these civilians working in Iraq, few were prepared for the escalating violence that has convulsed the country in the past month. The fighting not only endangers their lives but threatens to unravel the entire $30 billion American effort to reconstruct the country. Indeed, the upsurge in violence comes just as the government is awarding $10 billion in new contracts, and companies like Halliburton and Bechtel are trying to increase their presence there.

There is no exact count of the foreign civilians killed or wounded in Iraq, but the number certainly tops 50. Halliburton alone has reported that 30 of its employees have died since the war began last year. Scores of workers from a number of countries have recently been taken hostage, including American Thomas Hamill, who was captured after the Halliburton fuel convoy in which he was riding was attacked outside Baghdad. Bodies discovered in a shallow grave at the site of another convoy attack may be those of six other missing Halliburton employees, although as FORTUNE went to press, that had not been confirmed.

Given the danger, little work is getting done in Iraq these days. Convoys are stalled, waiting for protection, and workers are trying to keep a low profile. "We're in a lockdown," says Jack Herrmann, spokesman for Washington Group International, a Boise construction firm rebuilding Iraq's electrical grid and water systems. Washington Group's 90 employees are largely confined to guarded compounds, making it hard to repair electric lines or water pipes, although work on some power plants has continued. Staying in defended camps, however, still doesn't guarantee safety. "We've had bullets flying overhead and mortar shells lobbed in," Herrmann says. At two other project sites in Baghdad, up to 90% of the 250 Iraqi workers Washington Group has hired have failed to show up for the job because of death threats.

Even within Baghdad's Green Zone, the vast, heavily fortified quarter that surrounds the Coalition Provisional Authority headquarters and serves as the nerve center of the American occupation, civilians are advised to wear flak jackets and helmets. Travel outside the Green Zone into other parts of the city is not recommended, except for "mission critical" trips, and armed escorts must accompany all those leaving.

As civilians start to venture out again, the first order of business will be assessing the damage. In some areas of the country, insurgents have looted government buildings only recently renovated by contractors. But perhaps the greatest blow has been the extent to which the recent fighting sapped the goodwill of the Iraqi people. One State Department official in Iraq estimates that the current violence has set back the reconstruction effort by at least six months.

As of now, plenty of workers are still clamoring for jobs in Iraq. Halliburton processes several hundred through its training center in Houston each week. And Aerotek, a recruiting firm based in Baltimore, doesn't think it will have any trouble filling the 1,400 positions in Iraq--for engineers, truck drivers, warehouse workers, and mechanics--that its clients are seeking. "For us, this hasn't been a hard sell," says Todd Gardner, Aerotek's director of marketing. "We have people coming to us to find these positions." Some of those volunteering for jobs in Iraq are drawn by a sense of adventure or idealism. Bill Riedel, a Washington Group employee, is one of the idealists. He recently returned from six months working on a power plant in Bayji in northern Iraq. Despite his wife's misgivings, the 55-year-old Riedel says he's ready to go back in late April to a spot not far from Fallujah, the most dangerous place in the war-torn country. Although he could earn up to $150,000 as a construction manager there, he insists money isn't the draw. "I made as much on a job in Boston," says Riedel. "As archaic as it sounds, I still feel a need to help."

But for most contractors, it is about money--two to four times what similar positions pay in the U.S., and blue-collar workers often earn at least $100,000. Even better, those earnings are frequently tax-free.

As companies lay out large salaries as an incentive for nervous employees, they're also spending a lot more protecting and insuring them. Workers in dangerous locales typically get life insurance policies worth up to $1 million, and coverage costs have jumped 30% in recent weeks. Demand for kidnap and ransom insurance policies is also increasing, says David Lattin, an insurance executive with the St. Paul Cos.

Security costs are rising just as dramatically. When Halliburton teams working to rebuild oil pipelines first arrived in the country, they had military protection. But now they've had to hire private security. With armored SUVs running more than $100,000 apiece and armed guards earning $1,000 a day, big contractors like Bechtel and Halliburton are spending hundreds of millions to protect their employees. Since the government picks up the tab, ultimately that means fewer dollars for actual reconstruction work.

As the risks begin to outweigh the potential profits, contractors are starting to reconsider whether the job is worth it. Some workers are fleeing, and a few companies are seriously considering scaling back. Several governments, including Germany and Russia, have already ordered their nationals out of the country. Hundreds of Halliburton employees have asked to come home, and an e-mail from a top U.S. official in Iraq to the Pentagon warned that Halliburton might withdraw completely. Halliburton officials deny the company has any plans to leave Iraq, but the prospect of any sort of pullout alarms military planners. That's because the 134,000 American soldiers battling the insurgency are largely dependent on private companies--particularly Halliburton's KBR unit--for the delivery of fuel, food, and water.

If the companies leave, it will cripple the military's logistics effort. Halliburton already suspended some deliveries to the military for five days because of the fighting. "We have taken things that are at the heart of our ability to wage war and made them dependent on the market," says P.W. Singer, a scholar at the Brookings Institution, a Washington, D.C., think tank. Unlike soldiers, contractors can't be ordered to stay in a war zone. Stephen Heering, a Halliburton driver, decided to call it quits after his truck was blown out from under him earlier this month. "I'm done. I'll never go back," he told a reporter upon arriving home in Houston.

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