This is already fixed in upstream (in the manner the reporter suggests);
see commit d175caad25a4e80800d5e7e7d8c9d920a88b78e1 from
git://git.et.redhat.com/libvirt.git, attached.

I've applied that patch to libvirt0 0.4.0-2ubuntu8.  It applies cleanly
except for a reject on the changelog, and it does fix the problem.

(I ran across this trying to set up a virtual gfs2 cluster for testing;
it failed because cluster nodes rejected traffic that (due to thbe
unnecessary masquerading) appeared to come from the host instead of the
other (guest) cluster nodes.)

** Attachment added: "Tweak masquering rules to only capture traffic leaving 
the virtual network"
   
http://launchpadlibrarian.net/16140534/0001-Tweak-masquering-rules-to-only-capture-traffic-leavi.patch

** Changed in: libvirt (Ubuntu)
       Status: New => Confirmed

-- 
overzealous masquerading affects vm to vm traffic
https://bugs.launchpad.net/bugs/227837
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