Khanaqin, an Iraqi town that has refused to follow a central government directive that bans the use of the Kurdish flag in official buildings, lies within territory claimed by both the central government and authorities in the autonomous Kurdish capital of Irbil.
US officials persistently cite unresolved territorial rows between the two authorities as one of the biggest threats to Iraq's long-term stability.
Around 700 demonstrators marched from the centre of the town, 150 kilometres (90 miles) northeast of Baghdad and near the Iranian border, to local government buildings a kilometre away, an AFP journalist at the scene said.
They carried flags of the Kurdish region, demanding that government buildings in Khanaqin be allowed to hoist both it and the national flag of Iraq. They also called for an apology from Prime Minister Nouri Al-Maliki.
The protesters shouted "Long live Kurdistan!" and "Khanaqin is Kurdish!" during their rally.
The demonstration came a day after Kamal Kirkuki, speaker of the Kurdish regional parliament, told reporters at a news conference that "violating the sanctity of Kurdistan's flag is unacceptable."
Khanaqin mayor Mohammed Al-Mullah Hamed said the town received the ruling on Tuesday.
Kurdish authorities want to incorporate Khanaqin and a swathe of territory running from Iraq's border with Iran to its frontier with Syria into their three-province autonomous region, a claim fiercely opposed by Baghdad.
Tensions remain high over the zone.
They rose markedly in late February when, amid nationwide protests, Kurdish peshmerga fighters shifted southwest towards Kirkuk, the oil-rich ethnically-mixed city at the centre of the dispute, in what they said was a move to protect it.
The peshmerga eventually pulled back in late March.