Dozens of local councils risk losing hundreds of millions of pounds of taxpayers’ money held in Iceland’s stricken banks. Town halls across the country may have to raise council tax and cut services as the repercussions of the collapse of the Icelandic economy broadened into a diplomatic row with Britain.

Alistair Darling, the Chancellor, pledged yesterday to make good all losses suffered by the 300,000 British savers caught by the collapse of Icesave, the online bank that went into receivership on Tuesday. The move will cost the Treasury about £4.5 billion — and carried an implicit pledge from Mr Darling that he would do the same if other banks collapsed. The Government also seized control of the British arm of Iceland’s Kaupthing bank because it could not honour its obligations to customers.

Mr Darling expressed incredulity that Reykjavik was cold-shouldering British investors. “The Icelandic Government have told me, believe it or not, they have no intention of honouring their obligations,” he said. Britain started legal action yesterday in an effort to recover money belonging to Icesave customers.

The Government used anti-terrorism powers to freeze an estimated £4 billion of British financial assets in Landsbanki, Icesave’s parent bank. A spokesman for the Treasury said that the 2001 Anti-Terrorism, Crime and Security Act was invoked as a “precautionary measure”.

But the Chancellor refused to give town halls a guarantee that he would extend the same protection to them. He also infuriated councillors by suggesting that they would never have ended up in such a position if they had taken sounder financial advice.

Margaret Eaton, chairman of the Local Government Association, said that councils had followed Treasury advice to spread their assets as widely as possible and ensure the maximum return for their investments. Town halls regularly invested in a wide range of banks within strict guidelines drawn up after the collapse of BCCI in 1991, when several councils suffered heavy losses, she said. Mrs Eaton wrote to Mr Darling yesterday, asking for an assurance that their assets would be covered.

Admitting that some councils could be hit, she said that many would have to plunder reserves built up over years. But town halls are already on a financial tightrope with constant demands for higher efficiency savings, and several have their reserves and even pension funds invested in Icelandic banks, which paid higher interest rates.

Authorities in London are believed to have about £200 million in Icelandic banks. They include Westminster, which said it had £17 million split between Landsbanki and Heritable; Sutton — £5.5 million — and Havering, which has investments totalling £12.5 million. Outside the capital, Kent County Council said that it had £50 million deposited in Icelandic banks — £15 million with Glitnir Bank, £17 million with Landsbanki and just over £18 million in its British subsidiary, Heritable.

Michael White, the Havering Council leader, said: “Accounts in these banks have been frozen, but there is no indication at this time that our deposits will not be returned.”

In the Commons, Mr Darling said that town halls were better informed than personal investors, who may not have appreciated that Icesave was a branch of a foreign bank. Earlier Mr Darling announced that no individual British saver would lose money if Icesave’s parent company Landsbanki goes into receivership. But investors are still no clearer about when they will be able to retrieve their savings.

The Treasury also arranged for more than £3 billion of British savers’ money held with Kaupthing Edge and Heritable to be transferred to ING Direct. The deal was rushed through after the Financial Services Authority gave warning that neither was likely to be able to pay their British savers.

The Chancellor was forced to step in to guarantee Icesave’s deposits, which were frozen on Tuesday, after he failed to reach a compensation agreement with Reykjavik. All deposits with the ailing bank will be guaranteed by the British authorities, including those exceeding £50,000, the normal limit for compensation claims.

Officials indicated that it was likely that Icesave customers will be able to make a single application to the Financial Services Compensation Scheme.

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