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I read that the Lateran Treaty (which created the Vatican City State) specifically allows Italian police to patrol St. Peter's Square, even though the square is within Vatican City. Practically, what happens when an Italian police officer arrests someone (say a pickpocket, probably the most common scenario)?

Does the policeman just unceremoniously take the suspect across the international border into Italy and to the police station with no special process whatsoever or does he have to first take the suspect to the Vatican City police station to have him formally turned over to Italian custody (i.e. "extradited")?

It seems to me that if there is no special process, even the "rubber stamp" kind, it kind of undermines the national sovereignty of Vatican City over that part of its territory. The Italian police would just be treating it the same as if it's in Italy.

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There is in fact a “rubber stamp” requirement, stipulated in article 22 section 1 of the Lateran Treaty:

At the request of the Holy See, or by its delegation which may be given in individual cases or permanently, Italy will provide within its territory for the punishment of crimes committed within Vatican City (…)

Presumably, the Holy See (i.e. the pope and his government) has issued such a permanent delegation allowing Italian police and justice to take petty criminals arrested on St. Peter’s Square to Italian territory and to court. The Holy See could, in theory, revoke that delegation and decide over the extradition of each pickpocket individually, or even try all of them in its own courts and jail them on Vatican territory; however, the current regime, with law enforcement provided as a service by Italy, is much more convenient.

The Holy See is certainly forgoing a part of its sovereignty here. This is not at all uncommon, though, especially for special geographical situations such as border rivers or enclaves (and Vatican City happens to be one). As a somewhat comparable example, Swiss police is in certain cases allowed to make arrests in the German town of Büsingen and to transport the arrestee to Switzerland, without the involvement of German authorities.

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Article 3 of the Lateran Treaty states:

It remains understood that St. Peter's Square, although forming part of Vatican City, will continue to be normally open to the public and to be subject to the police power of the Italian authorities

However, the same article starts:

Italy recognizes the full ownership and the exclusive and absolute power and jurisdiction of the Holy See over the Vatican as it is presently constituted, together with all its appurtenances and endowments, creating in this manner Vatican City for the special purposes and under the conditions given in this Treaty.

To argue that article 3 undermines Vatican sovereignity is contrary to the clear language of the text. It is limiting it somewhat but that's frequently what a treaty does. However, it implies that there isn't a requirement for approval from Vatican authorities for extradition from St. Peter's Square.

In principle, therefore, the Italian police could act like idiots. Then the Vatican could close the square to the public and ask them to leave.

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