The Icelandic economy would be crippled if the country had to pay British savers in its stricken banks the full amount that Britain claims is due, the country’s Prime Minister said yesterday.

“I don’t want to make comparisons with Versailles, but the debt burden from this type of arrangement would be terrible,” Geir Haarde told The Times, referring to the 1919 treaty that left Germany laden with debt and fuelled the rise of Nazism. “It’s an enormous number. Everyone has to figure out for themselves whether that would be sustainable.

“There would be no backing in parliament for that kind of a deal,” he added, playing what may be his strongest card: that Iceland simply cannot afford to pay the sums that Britain claims it is obliged to find for foreign victims of its financial meltdown. Three weeks after the collapse of its entire banking system, Iceland is locked in a row with Britain over who should compensate savers. Each side is now careful to use cooler language than in the first eruption of insults, but they still clash on their interpretion of Iceland’s responsibilities under its membership of the European Economic Area.

“We clearly have some obligations in the matter, but the question is to what extent,” said Mr Haarde. “One would expect between two civilised and friendly countries that we can negotiate a solution or find a third party or a court of law to adjudicate.”

The main dispute is over the losses suffered by the 300,000 British holders of Icesave accounts with Landsbanki, one of three banks now in state hands. Gordon Brown has promised that Britain will guarantee the first £50,000 of each account, but the argument is over whether Iceland is bound by European rules to pay the first £16,500 of that amount. The total that may be liable — more than £4.5 billion — far outstrips the compensation fund set up by Icelandic banks, perhaps by more than 50 times, some officials say.

If the banks cannot pay, a further question is whether the obligation falls on the Icelandic Government.

Mr Haarde said that there were practical limits to what his Government could pay. The total guaranteed is nearly half of Iceland’s gross domestic product last year, whereas the amount in the banks’ fund is less than 1 per cent, officials suggest. Iceland has also instructed lawyers to investigate British actions, which it claims undermined the banks: namely, the use of terrorism laws to freeze Landsbanki assets, and a separate move to take into administration the British arm of Kaupthing, a second bank.

The $2 billion deal agreed with the International Monetary Fund on Friday was a third of the amount Iceland needed, the Prime Minister said. He still hoped that Russia might contribute, along with Nordic countries, although the recent announcement of a Russian loan came to nothing beyond alarming Iceland’s Nato allies. “We talked on my initiative in August, and in Moscow two weeks ago,” Mr Haarde said, “and will resume at a date to be determined.” Any deal “would not change our foreign and security policy”.

Mr Haarde, of the Independence Party, has opposed joining the EU or adopting the euro, but polls this week show that 70 per cent of Icelanders now support EU membership, while businesses argue that the volatility of the krona is intolerable.

In what appears to be a softening of his position, Mr Haarde said that while neither the euro nor the EU offered a solution to the immediate crisis, “in more calm waters, several years ahead, we might discuss it”.

Iceland’s desire to retain control of its 200-mile fishing zone — where it has managed stocks well, unlike the EU’s Common Fisheries Policy — remained the biggest single obstacle, he said.

The Prime Minister maintained that “within two years or so we will have the economy back on a sustainable path”, but added: “I don’t think international banking will become a major industry again here soon.”

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