The new cold war: Relations with Iceland are becoming perilously fraught over recompense for savers

But snow soon became the least of Myners' concerns as a cold war of an altogether different kind broke out.

All hopes of a quiet start to the year were quickly dashed on Tuesday when over in Reykjavik, the Icelandic president, Olafur Ragnar Grimsson, rejected a bill to repay a 3.6 billion loan to the British and Dutch governments. Until last week, Grimsson was a little known face in British political and media circles but within minutes, his surprise decision to put the bill to a referendum became the talk of the town.

The UK and the Netherlands had assumed that the "Icesave bill", so-called because the loan was extended to compensate British and Dutch savers who saw their accounts frozen when the online Icelandic bank, Icesave, collapsed in 2008, would finally get the seal of approval last week. Although it has proved deeply unpopular with the Icelandic public, it scraped parliamentary approval just before the new year. It had been presumed that the bill's approval by Grimsson was likely to be a matter of ceremony.

But as the news of his refusal to rubber stamp the agreement filtered through, it was quickly interpreted in London and the Hague as a declaration of diplomatic war.

Myners' Treasury foot soldiers scrambled to mount a defence and it wasn't long before the financial services minister issued a sharp warning that Iceland risked being frozen out of the European Union if voters came out against the loan. Such a move would also harm Iceland's relationship with the IMF and turn it into an international pariah, Myners said.

With tempers high on both sides of the North Atlantic, parallels were drawn with the "Cod Wars" of the Seventies when gunboats were sent to patrol contested fishing waters.

The dispute dates back to 2008 when some 298,000 British savers, and thousands more in the Netherlands, saw their accounts frozen when Icesave, the online subsidiary of failed Icelandic bank Landsbanki, collapsed at the height of the global banking crisis.

Although British savers were not strictly covered by the UK's Financial Services Compensation Scheme, which insures against losses of up to 50,000, Gordon Brown's government promised to reimburse those Britons who had been lured by Icesave's high interest rates.

Analysts say there was a confidence within the walls of Whitehall that, given Britain's friendly diplomatic relations with Iceland since the mid Seventies, a deal could be struck to recoup the losses, even though Reykjavik was not legally obliged to extend compensation to UK citizens.

But according to Dragana Ignjatovic, a specialist on Iceland at IHS Global Insight, Britain severely harmed its chances of resolving the situation amicably when on 8 October 2008, one day after Landsbanki was nationalised by the Icelandic Government, Westminster invoked UK terrorism laws to seize control of Landsbanki's British assets.

Ignjatovic says: "In October 2008, everything was spiralling out of control and that move was pure panic on the UK Government's behalf. But Icelanders saw it as an extremely hostile act. It basically listed Iceland alongside al-Qaeda."

The situation deteriorated further when at the end of October 2008, Iceland went cap in hand to the IMF for more than $2bn (1.25bn). Although the IMF hotly denies that its aid was dependent on a deal with the British and Dutch governments, Ignjatovic says the fact that a large tranche of IMF funds was not released until assurances about Icesave were secured, was poorly received in Reykjavik.

She says: "Icelanders felt held to ransom by the international community for something that they saw as the fault of bankers and regulators."

The passage of the Icesave bill through the Icelandic Parliament, the Althingi, last year was fraught with difficulty as the Icelandic public vehemently objected to repayments, which they believe would push the country into bankruptcy.

Iceland attempted to lessen the severity of the loan's terms in June by presenting the UK and the Netherlands with a deal that would cap annual repayments at 6 per cent of GDP, a proposal which was swiftly rejected by both London and the Hague.

Instead, Iceland was forced to settle on a 15-year loan at an interest rate of 5.5 per cent.

Although international economists claim that the final terms are relatively modest, given that they include a seven-year grace period and a chance to renegotiate in 2014, Icelanders have continued to decry the fact that every single citizen would be saddled with a contribution of ?12,000.

Anger towards the bill continued to mount at the end of last year with the most recent opinion polls showing that 70 per cent of Icelanders are strongly opposed to it.

The bill did finally gain the approval of the Althingi in December but Alyn Smith, SNP member of the European Parliament and head of Europe's Iceland delegation, says the UK and Dutch governments should not, in hindsight, have been surprised at Grimsson's actions last week. He argues that Iceland's president is bound by the country's constitution to only approve a law if he is confident that it has the support of the majority of the Icelandic people.

Smith says: "It wasn't actually Grimsson's choice to refuse to sign the bill. Iceland is a true democracy and the president can only sign an act of parliament if he thinks it's the true wish of the people."

The Icelandic parliament was recalled early on Friday to thrash out the details of the referendum. It is expected the bill will be put to the public vote at the end of next month.

Despite the UK's threat to block Iceland's entry to the European Union, Smith, who trained as a financial services lawyer, argues that there is very little Britain and the Netherlands can do if the Icelandic people vote "no". Although they could veto Iceland's accession, they only hold one vote each and some other countries are more sympathetic to Reykjavik's plight, Smith suggests.

He says: "The Nordic countries in particular are very sympathetic towards Iceland and not sympathetic towards the UK. The use of terrorism legislation by the UK government was very ropey politics and there is a lot of resentment that Iceland has been singled out. It was done in a way that was just disgraceful against a friendly power."

Legal experts point out that Britain and the Netherlands would also struggle to pursue the 3.6bn through the courts.

One lawyer involved in negotiations over the Icelandic banks said: "As Iceland is not a member of the European Union there are no international laws which directly bear on the issue and would be enforceable by going to court. The position would have been different if Iceland had been a member of the EU."

However, Ignjatovic of IHS Global Insight argues that Iceland will also be doing itself few favours if it does not come to an agreement with Britain and the Netherlands. She points out that credit rating agency Fitch last week downgraded Iceland's debt to "junk" status. Added to this Spain, which currently holds the EU presidency, threw its weight behind London and the Hague on Friday, saying the referendum would likely delay Iceland's entry to the EU.

Spanish foreign minister Miguel Angel Moratinos said: "Clearly if it (the bill] is not approved, it could slow down the whole calendar... it could slow the whole process of negotiations."

Finland said on the same day that the ?350m it has pledged as part of a Nordic loan package would be contingent on Iceland meeting its "international commitments".

Ignjatovic says: "Not paying back the money is not really a viable option for Iceland. If they don't pay back at least some of the funds then it will be very detrimental to their chances of rehabilitating their financial services. Ultimately, I think everyone will have to go back to the negotiating table."

However, Ignjatovic suggests that a "no" vote at the referendum will strengthen Iceland's negotiating position with Britain and Holland. She says: "They will be able to go back and say: 'Look we tried this but it was rejected by the people.'"

She suggests that London and the Hague will, as a result, feel pressure to take a softer line. "They're starting to look like bullies," Ignjatovic warns.

After the diplomatic spat broke out on Monday, Grimsson attempted to prevent the situation from deteriorating into a war of attrition by assuring on UK television that the referendum was likely to be based on the terms of repayment, not on the question of repayment itself.

He said Iceland would, in some form or another, "honour its obligations". But he also warned UK politicians to tread carefully as Iceland's 243,000 voters are paying careful attention to their threats. Grimsson said: "It's important for Alistair Darling and Gordon Brown to realise that a few minutes after they speak to their home audience in Britain everything they say is being talked about in Icelandic fishing plants and every village and every office."

Political analysts expect the war of words between the two governments to roll on this week but Smith warns that both sides need to proceed with caution. "They could harm important trade relations," he says.