British fury after Iceland blocks £2.3bn repayment

But on the streets of Reykjavik, Archie Bland finds Icelanders celebrating the success of people power

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.

"It is surprising, but the President was right to do it without a doubt," said Eirikur Svavarsson, a member of the nine-person InDefence group behind the petition that forced the issue.

While Iceland is still nominally committed to paying back the money – which equates to some 40 per cent of GDP – no concrete means of doing so is in place. The now vetoed bill – which passed parliament after considerable pressure from the British Government – featured severe consequences for Iceland if it failed to make repayments that would cover the first £19,000 in each British Icesave account. Under the only agreement that now applies, however, any money not paid back by 2024 will be written off.

Despite public satisfaction at the veto, the outlook for the tiny Icelandic economy looks no cheerier today than it did before. The credit agency Fitch yesterday downgraded Iceland's credit rating to junk status, saying the President's decision "creates a renewed wave of domestic political, economic and financial uncertainty" and represents "a significant setback to Iceland's efforts to restore normal financial relations with the rest of the world". As well as the damage to Reykjavik's hopes of joining the EU, fears remain that a second tranche of loans from the International Monetary Fund will be delayed, despite the organisation's reassurances last night that the Icesave situation would not affect the deal.

The British City minister Lord Myners warned that Iceland would be excluded from the global financial system if it refused to "comply with its international obligations". A "no" vote in the referendum, he said, would be tantamount to saying Iceland does not want to be "regarded as a safe counter-party with whom to do business". He added: "I don't think the Icelandic people would be sensible if they reached that conclusion."

Most Icelanders, though, were hard-pressed to come to any firm conclusions. With the unprecedented referendum process cloudy, and no date set, the next few months remain unclear, as do the President's motives for his stunning decision. "I think he sensed an opportunity to become the hero who saved the nation from the crisis," said one political public relations consultant. "But most people are still very, very afraid of what is in the future. We haven't the faintest idea what will happen."

Icelandic saga Q&A

Why has the Icelandic President vetoed the repayment plan?

Politics. A quarter of the population signed a petition calling for the bill not to be passed. Icelandic taxpayers don't see why they should suffer for the actions of their bankers. The compensation package amounts to nearly £11,000 each for the 320,000 citizens.

Will this affect people who saved with Icesave?

No. The UK Government stepped in to bail out savers when Icesave's owner, Landesbanki, collapsed in 2008. But yesterday's veto means London will not be reimbursed – at least for now.

Do the Icelanders have a point?

It might look like they have, but here's the problem: under the current international banking system, if a bank fails, it is its home country that takes responsibility for dealing with the mess. When Royal Bank of Scotland was bailed out, the US, for example, wasn't required to put up a penny despite RBS's sizeable US business.

What are the consequences?

The move is not risk-free for Iceland, whose battered economy needs the help of the IMF, help which is contingent on it meeting its obligations to the UK and the Dutch. The IMF could act to block a second tranche of loans to Iceland. The move could also complicate the country's hopes of joining the European Union, although the Icelandic people are less keen on this than they once were.

James Moore