Reaching agreement with the two European Union countries is vital for the continued flow of aid to Iceland, which is still in the grip of a devastating recession and needs funds to help bring its economy back to a more normal footing.

But Icelandic President Olafur Grimsson unexpectedly refused to sign an amended law this week on repayment, citing a wave of popular anger over the bill and forcing a referendum on the highly contentious issue.

British and Dutch depositors in high-interest "Icesave" bank accounts lost their money when Iceland's entire financial system imploded in late 2008 under a massive weight of debt.

The two countries compensated their savers in full and want their money back from Iceland.

The government now plans to hold a referendum late in February or early in March, but the result is highly uncertain with opinion polls suggesting a majority of the 320,000 Icelanders oppose the so-called Icesave bill.

"They have to decide the date and the law is quite simple," said Einar Haraldsson, spokesman at the prime minister's office.

"There will be a debate on the phrasing of the question."

If the new Icesave law is rejected, an earlier version - passed during the summer - enters into force.

Britain and the Netherlands said the terms outlined under the earlier bill were unacceptable, mainly because repayments would not be guaranteed by the Icelandic government after 2024.

Spain, which holds the EU presidency, said the issue could hold up Iceland's progress towards joining the 27-nation bloc.

"Clearly if it (the bill) is not approved, it could slow down the whole calendar...it could slow the whole process of negotiations," Spanish Foreign Minister Miguel Angel Moratinos said.