The policemen were on a patrol in Kedma when they stopped a driver and searched him.
They then found the illegal handgun with an engraved inscription in Arabic, Israeli broadcaster Arutz Sheva reported.
"A gift from the President of Iraq, Saddam Hussein, to one who defended his homeland," the inscription says.
Police arrested the four occupants of the car and interrogated them. Three of the four were released, Arutz Sheva said.