The International Atomic Energy Agency said medium-level enrichment had begun at the Fordo plant, in northern Iran.
Tehran has said it plans to carry out uranium enrichment there for purely peaceful purposes. The West argues Iran is building a nuclear weapons capacity.
The US said the Fordo work was a “further escalation” in the row. The UK and France also condemned the project.
The existence of the facility near Qom, in the north of the country, only came to light after it was identified by Western intelligence agencies in September 2009.
Tehran said it began the project in 2007, but the IAEA believes design work started in 2006.
BBC Iran correspondent James Reynolds says the facility has attracted plenty of attention and suspicion.
It is underground, heavily fortified and protected by the armed forces – making it a very difficult target for air strikes.
The US and Israel have refused to rule out attacks on Iranian facilities.
On Monday, a spokeswoman for International Atomic Energy Agency (IAEA), Gill Tudor, said the agency could “confirm that Iran has started the production of uranium enriched up to 20%”.
She added that “all nuclear material in the facility remains under the agency’s containment and surveillance”.
Iran insists enriched uranium is needed to make isotopes to treat cancers. But analysts say 20% enrichment is an important step towards making uranium weapons-grade.
In Washington, state department spokeswoman Victoria Nuland said such a level of enrichment was “a further escalation” of the Iranians’ “ongoing violations with regard to their nuclear obligations”, and suggested “a different kind of a nuclear programme”.
In Paris, a statement by the foreign ministry said the Iranian move “leaves us with no other choice but to reinforce international sanctions and to adopt, with our European partners and all willing countries, measures of an intensity and severity without precedent”.
British Foreign Secretary William Hague condemned the “provocative act which further undermines Iran’s claims that its programme is entirely civilian in nature”.
Atomic bomb joke
Earlier on Monday, Iran’s Supreme Leader Ayatollah Ali Khamenei insisted Iran would not bow to pressure from the West.
“The Islamic establishment… knows firmly what it is doing and has chosen its path and will stay the course,” he said in a speech broadcast on state television.
Meanwhile, Iranian President Mahmoud Ahmadinejad – who is currently on a visit to Venezuela – received a strong backing from President Hugo Chavez.
“They present us as aggressors,” the Venezuelan leader said, referring to US government officials. “Iran hasn’t invaded anyone. Who has dropped thousands and thousands of bombs… including atomic bombs?”
The Iranian and Venezuelan presidents also joked about having an atomic bomb at their disposal.
“That hill will open up and a big atomic bomb will come out,” Mr Chavez said, laughing.
“The imperialist spokesmen say… Ahmadinejad and I are going into the Miraflores (presidential palace) basement now to set our sights on Washington and launch cannons and missiles… It’s laughable.”
Tensions have been high since the US imposed new sanctions on Iran’s central bank and the European Union said it would place an embargo on Iran’s oil exports.
EU foreign ministers are due to meet to approve the embargo later this month.
Iran has threatened to close the Strait of Hormuz – a key route from the Gulf through which 20% of the world’s traded oil passes.
Defence Secretary Leon Panetta warned on Sunday that such a move would cross a “red line” and “we would take action and reopen the strait”.
Adding to the strains, a court in Tehran on Monday sentenced to death an Iranian-American man accused of being a CIA spy.
Amir Mirzai Hekmati, 28, a former US marine, had been show on state television in December allegedly confessing to being part of a plot to infiltrate Iran’s intelligence services for the CIA.
Our correspondent says Iran’s judicial and political systems place huge emphasis on the importance of confessions, which are viewed with concern by human rights groups.
Mr Hekmati’s family, who live in Arizona, say the charges against him are fabricated and that he was in Iran to visit his grandmothers. The US has demanded his release.
Report by : BBC