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WPC Yvonne Fletcher had been helping control a small demonstration outside the embassy when automatic gunfire came from outside.
She received a fatal stomach wound and some of the demonstrators were also severely injured.
WPC Fletcher, 25, died soon afterwards at Westminster Hospital.
Her fiancé, another police officer who was also at the demonstration, was at her side.
After the shooting people were cleared from surrounding offices in St James' Square.
Some had witnessed events from their workplace.
Film maker Ray Barker said people were stunned by what had happened.
"Several of my colleagues burst into tears. It was unbelievable that sort of thing could happen at such an insignificant demonstration," he said.
Journalist Brian Cartmell was in St James' Square just feet away from Yvonne Fletcher when she was hit.
"She crumpled to the floor clutching her lower stomach and groin and rolled on to her right-hand side with a look of total surprise on her pretty face," Mr Cartmell said.
The Libyan building is now surrounded by armed police officers including specialist marksmen.
However, Home Secretary Leon Brittan has said the police are prepared to wait and deal with the situation in a peaceful way.
Police officers are in touch with those inside the Libyan People's Bureau via a special telephone link.
The Libyans, led by Colonel Gaddafi, are blaming Britain's police and security forces for "attacking" their embassy.
Libyan soldiers have now surrounded Britain's embassy in Tripoli trapping 18 diplomats inside.
Diplomatic relations with Libya were severed on 23 April.
British diplomats in Libya who had been trapped in their embassy were allowed to leave.
The Libyans were ordered out of UK and left peacefully but due to their diplomatic immunity police were unable to question suspects before they went.
However, in 1986 a British businessman who had worked for Colonel Gaddafi's regime reported WPC Fletcher's killer had been hanged as soon as he returned to Libya.
Britain restored diplomatic relations with Libya in 1999 after the Libyan Government admitted it bore "general responsibility" for WPC Fletcher's death.
It also paid a six-figure sum in compensation to her family.
'I was there'
I was a guardsman mounting Royal Guard on that day. We were doing guard mount in the forecourt of Buckingham Palace and heard the shots fired.
I was senior soldier on St James' Palace detachment. It is the only time in 16 years as a guardsman that I was issued ammunition.
The police we spoke to were really angry, and in a very sombre mood and no wonder really.
They where saying even then that they thought that whoever had done it was going to get away with it.
From where we were, we could make out snipers on rooftops and see the general activity around and about.
The next morning a Middle-Eastern-looking guy was arrested on TV carrying a very large machette. He was brought to the Guardroom and kept there in cuffs for about 10 minutes before being carted off to the police station.
Andy Buchanan, former Grenadier Guard
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