Britain and Iceland engaged in a full-scale diplomatic spat yesterday as leaders of the two countries traded angry words about the handling of the financial meltdown.

Gordon Brown denounced the “unacceptable” behaviour of the Icelandic authorities, who froze the accounts of hundreds of thousands of British savers, accusing them of taking illegal action.

“What happened in Iceland is completely unacceptable,” the Prime Minister told the BBC. “I’ve been in touch with the Icelandic Prime Minister, and I’ve said that this is effectively illegal action that they’ve taken. They have failed not only the people of Iceland, they have failed people in Britain.”

For his part, an angry Geir Haarde, his Icelandic counterpart, accused Britain of performing an “unfriendly act” against his country by using antiterrorist legislation to seize Icelandic accounts. This was no way, he said, to treat a Nato ally.

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No warships have been dispatched to the North Atlantic but there is no longer any doubt that the financial collapse in Iceland is becoming the worst crisis in relations between London and Reykjavik since the Cod War of the 1970s.

“I certainly thought so this morning when I woke up to find that counter-terrorist laws were being used against us,” said Mr Haarde in response to a question from The Times. “This was very unpleasant, and I told the British Chancellor of the Exchequer that we are not pleased with this at all.”

Mr Haarde called Alistair Darling just before lunch yesterday and let off steam, officials said. “I told him that I considered this to be an unfriendly act,” he said.

Mr Darling first enraged the Icelandic Government by threatening legal action in an attempt to secure full compensation for British savers trapped by the collapse of the Landsbanki bank. More than 300,000 British savers have deposits in the bank’s internet operation, Icesave.

Then came the British seizure of assets. Yesterday the Icelandic leader suggested that this was what had nudged his government into nationalising Kaupthing, the largest bank in the country, on Thursday morning.

The scorecard in Iceland’s financial catastrophe so far: one major bank nationalised (Kaupthing); two in receivership (Landsbanki and Glitnir); and the stock exchange suspended until Monday. The value of the Icelandic króna plummeted briefly to 340 for €1. Just two days ago the over-the-counter exchange rate was 155 króna.

The heated conversation with Mr Darling appears to have concentrated on the need to keep some of Landsbanki’s operations going in Britain. “It’s very important that normal business continues as usual for Icelandic companies in Britain,” the Prime Minister said. “After all, it affects the jobs of 100,000 people, many of them UK citizens.”

Mr Haarde and Mr Darling agreed that Britain would send a small team of financial experts to the island to clarify matters further. Mr Darling is also due to meet his Icelandic counterpart at the International Monetary Fund meeting in Washington this weekend.

The Icelandic Government, though profoundly irritated, has enough on its hands without launching into a diplomatic confrontation with Britain. Certainly the Icelandic foreign ministry seemed to be doing what it could to sugar the lives of visiting British journalists. A trip to the thermal waters of the Blue Lagoon was on offer yesterday, perhaps in an attempt to get correspondents out of the capital; reporters, too, were encouraged to attend the opening of the Imagine Peace Tower, Yoko Ono’s memorial to John Lennon.

The conflict is, however, rapidly becoming as ill-tempered as the hot days of the last Cod War when Icelandic coastguards cut the nets of British trawlers fishing in Iceland’s self-proclaimed economic exclusion zone. This time around ordinary Icelanders are more preoccupied with the problems of managing everyday life without a properly functioning banking system. Property deals are on hold, and companies relying on imports are in trouble because of the plunging currency. So, too, are Icelanders who bought houses and cars on loans denominated in foreign currencies. A financial crisis centre is being set up to help those worst affected.

“Many people will lose their jobs in the banking sector,” Mr Haarde said yesterday. “Many shareholders will lose fortunes, and we will have to do our best to ease the pain.”

Although the Prime Minister tried to crack a few strained jokes while talking to the press yesterday, it is clear that the mood in Reykjavik is growing darker. Yesterday, for the first time, Mr Haarde was accompanied by a phalanx of security guards. This is almost unprecedented on this island where everybody appears to be a cousin of somebody else.

The President of Iceland, Olafur Ragnar Grimsson, had heart surgery this week, thus removing a popular figurehead who could have helped to calm the nation. Instead it appeared that the entire financial and political system of Iceland was suffering from a form of cardiac arrest.

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