Britain has warned Iceland it risks international financial isolation if it votes against a bill to compensate Britain and the Netherlands over the failure of Icesave bank.

Financial services minister Paul Myners also said controversy over the 3.8 billion euro (RM18.8 billion) compensation deal could impact on Britain's support for Iceland's bid to join the European Union.

Iceland's president on Tuesday refused to sign an unpopular bill to compensate Britain and the Netherlands over the failure of Icesave bank, triggering anger in London and The Hague.

Grimsson said in a televised speech that he would put the bill to a referendum instead.    

"The Icelandic people, if they were to reach that conclusion, would effectively be saying that Iceland doesn't want to be part of the international financial system, that Iceland doesn't want to have access to multinational, national and bilateral funding and doesn't want to be regarded as a safe country with whom to do business," Myners told the BBC on Tuesday.

"This development (would) need to be factored into a decision as to whether we would be supportive of Iceland's application to join the EU."

"But that's early days yet," he added.

The warning came after Britain’s Treasury said it expected Iceland to "live up to its obligations."

"The Treasury will consult with colleagues in Iceland to understand why this bill has not been passed and will work with them, the Netherlands and within the EU to resolve this issue as soon as possible," the spokesperson added.

In the Netherlands, finance ministry spokesman Ruud Slotboom told AFP : "We are extremely disappointed."

"The Netherlands maintains that Iceland is compelled to pay back the money. We expect of the government of Iceland to give us an explanation in the short term of the situation now created and the steps to be taken," said Slotboom.

Unpopular bill

The Icesave bill, narrowly approved by the Icelandic parliament on December 31, calls for the payout to the British and Dutch governments for having compensated more than 320,000 British and Dutch savers who lost money in the collapse of the Icelandic bank.

Icesave - an online subsidiary of the Landsbanki bank which had to be rescued in October 2008 - attracted foreign savers because of its high interest rates.

But they lost their savings when accounts were frozen during the devastating credit crunch. The British and Dutch savers were partially compensated by their own governments, which then turned to Reykjavik looking for the money paid out.

The payout has stirred up resentment among many ordinary Icelanders hard hit by their country's financial meltdown in October 2008.

About 60,000 people - about a quarter of the country's electorate - have signed a petition protesting against the bill and calling for the issue to be put to a referendum.

A poll taken in August suggested that nearly 70 percent of Icelanders were against the Icesave deal, the compensation amounting to about 12,000 euros (RM58,630) for each citizen on the small island nation.

In refusing to sign the bill, Grimsson said: "Public opinion polls indicate that the overwhelming majority of the nation is of the same opinion."

"I have decided, according to Article 26 of the Constitution, to refer this new Act to the people... The involvement of the whole nation in the final decision is therefore the prerequisite for a successful solution, reconciliation and recovery."

Fitch Ratings immediately downgraded Iceland's long-term debt rating from BBB- to BB+, citing a "renewed wave of domestic political, economic and financial uncertainty".

The agency said the president's decision "represents a significant setback to Iceland's efforts to restore normal financial relations with the rest of the world".

Bid to join EU complicated

Icelandic Prime Minister Johanna Sigurdardottir, meanwhile, has staked her political future on passage of the bill, saying in the past that her government could step down if it were blocked.

She told a press conference the government would start preparing the referendum and that she would be meeting with members of her governing coalition to decide what steps to take to ensure the survival of the government.

"We express disappointment with our president's decision," she told reporters, adding "the president's decision could have great consequences for the economic plan with the IMF".

Sigurdardottir, a Social Democrat elected in an April 2009 election triggered by the meltdown of Iceland's banks, added in a statement that Iceland's government was "committed to ensuring that Iceland honours its international obligations".

The dispute over the Icesave compensation scheme had delayed the disbursement of funds under a 2.1-billion-dollar IMF standby loan arranged in November 2008 following the collapse of Icelandic banks.

The IMF announced on December 14 that it had reached an agreement with Iceland on the release of a third instalment of the loan.

An earlier hold-up in implementing the Icesave compensation scheme had threatened to complicate Iceland's bid to join the European Union.

- AFP