Europe January 6, 2010, 10:21AM EST

Europe Furious over Icelandic Bank Veto

Netherlands and the U.K. were outraged by Iceland's decision not to reimburse them for covering deposits of British and Dutch savers in a failed Icelandic bank

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Iceland's president stunned his nation yesterday by refusing to sign off on a plan to repay £2.3bn owed to the British taxpayer, reigniting a major diplomatic row with London and leaving Gordon Brown and Alistair Darling mortally embarrassed at the latest twist in the saga of Reykjavik's banking meltdown.

A repayment plan for the debt, owed after the British Government paid compensation to UK savers who lost money in the collapse of the Icelandic internet bank Icesave, had been approved by Iceland's parliament despite huge opposition. But yesterday, in a move that horrified the ruling coalition, President Olafur Ragnar Grimsson declared that MPs had failed to take public opinion into account, and called a referendum. It was an extraordinary step for a ceremonial President, and only the second presidential veto in the republic's 66-year history.

"The people must be convinced that they themselves determine the future course," Mr Grimsson said in a televised statement that drew a jubilant response from many Icelanders, one fifth of whom had signed a petition opposing the repayment plan. "Now the people have the power and responsibility in their hands."

The response from Britain – and the Netherlands, which is expecting repayment on a €1.3bn (£1.16bn) loan – was furious. The Prime Minister's official spokesman said: "The Government expects the loan to be repaid. We are obviously very disappointed by the decision by the Icelandic President, but we do expect Iceland to live up to its legal obligations and repay the money."

The Treasury said it was setting up urgent meetings with Icelandic ministers. A senior government source said: "When we made the deal with Iceland, we had no idea that it would not be honoured. It is an awful lot of money." Britain is also consulting the European Union and the Dutch government, which likewise declared itself "very disappointed".

That ominous international reaction dismayed the Icelandic government, which is desperate for EU membership as a firewall against similar economic catastrophe in the future. The ruling coalition was wrong-footed by the President's dramatic announcement, with the Prime Minister Johanna Sigurdardottir admitting that she had had "no idea" that Mr Grimsson would call a referendum, and managing only a vague assurance that Iceland "honours its international obligations". She was overheard yesterday saying it was unclear that the government could survive if it came to a referendum.

However, ordinary Icelanders – many of whom remain angry at Mr Brown's use of anti-terror legislation to freeze Icelandic assets in the UK after the country's banking system collapsed – were delighted. Some 70 per cent of the public opposed the legislation.

"The government didn't listen to the people," said Davio Guomundsson, bullish despite temperatures of -4C outside the Althing, the parliament, last night. "Whatever happens, it's good that now we'll be heard, here and abroad." Property manager Leifur Welding voiced similar defiance. "We have already been in a war with Britain – a cod war," he said. "We won that. We're ready to have another one."

But the decision could send shockwaves through Iceland and beyond.

Government supporters are now worried that the President's action will have dire economic consequences. "In the last weeks we've been seeing good signs again, we've been rising from this deep depression, and now we're back to square one," said Lara Juliusdottir, chair of the supervisory board of the Central Bank of Iceland. "It is really a shock that we couldn't go through with it. The President is just an old politician – he always wants to be in the spotlight. Everything here is just a big question mark now."

The lengthy wrangling has only served to highlight the divide between Reykjavik's government, grasping for a solution to a crisis that it believes is not of its making, and a popular opposition movement that remains outraged by the prospect of a bill that would amount to £11,000 for each of the country's 320,000 citizens.