The lawsuit filed last week by Ayman Abu Aita in federal court seeks $110 million in damages.
In the movie, Cohen plays a gay Austrian fashion journalist trying to make it big in the United States. To achieve worldwide fame, Bruno travels to the Middle East to make peace. He interviews Abu Aita, and a caption labels the Bethlehem shopkeeper as a member of the militant Al-Aqsa Martyrs' Brigade.
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Abu Aita is suing CBS and Letterman's company Worldwide Pants over an interview before the film's release where the Late Show host and Cohen discussed Bruno's encounter with a "terrorist."
In the interview, Cohen, 37, said he set up the meeting in the West Bank with the help of a CIA agent. Cohen said he feared for his safety and interviewed the "terrorist" at a secret location chosen by Abu Aita. A clip was then played on "The Late Show with David Letterman."
According to the lawsuit, however, the interview with Abu Aita took place at a hotel chosen by Cohen and located in a part of the West Bank that was under Israeli military control.
Film distributor NBC Universal and director Larry Charles are also named in the lawsuit.
A spokeswoman for Universal Studios declined to comment. Tom Keaney, a spokesman for David Letterman, also said he would not comment.
Cohen, a British comedian, also faced multiple lawsuits after his earlier movie, "Borat," including one for $30 million filed by residents of a remote Romanian village who said they were misled into thinking the project was a documentary about poverty. Most of the lawsuits were thrown out.
Abu Aita is prominent businessman, a Christian and a "peace-loving person who abhors violence," the latest lawsuit states. Before the film, he "enjoyed a good reputation for honesty and a peaceable nature" in his community, Abu Aita's lawyers wrote.
They go on to write that any accusations or insinuations that Abu Aita is or ever was associated with the Al-Aqsa Martyrs' Brigade, or any other terrorist activity is "utterly false and untrue."
Attorney Joseph Peter Drennan said Abu Aita was never offered a release to sign to appear in the film.
"This is an important lawsuit because it is about the dignity of a specific person. It is about his reputation, about his standing in the community," Drennan said.
"It addresses a very corrosive and calumnious slur against any young Palestinian who would be a political activist on the West Bank" who would be called a "terrorist" because of his activism.
Hatem Abu Ahmad, Abu Aita's Arab-Israeli lawyer, said Cohen made millions "on the back of my client."
The film drew disdain from the Israelis and Palestinians portrayed in a place Bruno calls "Middle Earth."
Drennan said he expects a hearing on the Abu Aita's complaint in late January.