Colleagues of Gillian Gibbons, 54, from Liverpool, said she made an "innocent mistake" by letting the six and seven-year-olds choose the name.
Ms Gibbons was arrested after several parents made complaints.
A spokesman from the British Embassy in Sudan's capital, Khartoum, said it was unclear whether she had been charged.
Embassy officials are expected to visit Ms Gibbons in custody later.
"We are in contact with the authorities here and they have visited the teacher and she is in a good condition," an embassy spokesman said.
The spokesman said the naming of the teddy happened months ago and was chosen by the children because it is a common name in the country.
"This happened in September and the parents did not have a problem with it," he said.
'Very sensitive'
The BBC's correspondent Amber Henshaw said Ms Gibbons' punishment could be up to six months in jail, 40 lashes or a fine.
The school has been closed until January for fear of reprisals.
Fellow teachers at Khartoum's Unity High School told Reuters news agency they feared for Ms Gibbons' safety after receiving reports that men had started gathering outside the police station where she was being held.
The school's director, Robert Boulos, said: "This is a very sensitive issue. We are very worried about her safety.
Mr Boulos said Ms Gibbons was following a British national curriculum course designed to teach young pupils about animals and this year's topic was the bear.
Ms Gibbons, who joined the school in August, asked a seven-year-old girl to bring in her teddy bear and asked the class to pick names for it, he said.
"They came up with eight names including Abdullah, Hassan and Muhammad," Mr Boulos said, adding that she then had the children vote on a name.
Twenty out of the 23 children chose Muhammad as their favourite name.
Mr Boulos said each child was then allowed to take the bear home at weekends and told to write a diary about what they did with it.
He said the children's entries were collected in a book with a picture of the bear on the cover and a message which read, "My name is Muhammad."
Book seized
The bear itself was not marked or labelled with the name in any way, he added.
It is seen as an insult to Islam to attempt to make an image of the Prophet Muhammad.
Mr Boulos said Ms Gibbons was arrested on Sunday at her home inside the school premises after a number of parents complained to Sudan's Ministry of Education.
He said police had seized the book and asked to interview the girl who owned the bear.
The country's state-controlled Sudanese Media Centre reported that charges were being prepared "under article 125 of the criminal law" which covers insults against faith and religion.
No-one at the ministries of education or justice was available for comment.
One Muslim teacher at the independent school for Christian and Muslim children, who has a child in Ms Gibbons' class, said she had not found the project offensive.
"I know Gillian and she would never have meant it as an insult. I was just impressed that she got them to vote," the teacher said.
In Liverpool, a family spokeswoman said Ms Gibbons' grown children, John and Jessica - both believed to be in their 20s - were not commenting on her arrest.
"I have spoken with her children and they do not want to say anything and aggravate the situation over there," she said.
Friends and neighbours of Ms Gibbons expressed their worry for the former deputy headteacher and respected educator who moved to Sudan in July.
"Gillian is a very talented and able teacher and she was extremely popular with the pupils at this school," said Gillian Jones, Ms Gibbons former colleague at Dovecot Primary School in suburban Aigburth.
Cartoons depicting Muhammad printed in several European newspapers sparked violent protests around the world in 2006.
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