The overnight attack took place in the center of Baquba, the capital of Diyala province, with militants temporarily occupying several neighborhoods.
The city, located just 60 kilometres (37 miles) north of Baghdad, is the closest the fighting has come to the capital since a major militant offensive swept down from the north last week.
The offensive is led by militants from the Islamic State of Iraq and the Levant (ISIL) but also involves other groups, including supporters of ousted dictator Saddam Hussein, AFP reported.
Security forces performed poorly during the initial assault, in some cases abandoning uniforms and vehicles to flee, but seem to be recovering from the shock of the onslaught and have begun to push back.
The militants began making sweeping gains when they took control of Mosul, Iraq's second-largest city, on June 9. Since then they have pushed south, also taking Tikrit.
Fallujah has been in militant hands since a January offensive that saw them take control of the city as well as other areas of Anbar province.