The Government could face legal action within weeks over its decision to put the UK arm of Kaupthing, the failed Icelandic bank, into administration.

Lawyers in London are preparing the groundwork for a judicial review in the High Court that would challenge the decision by the Treasury to seize control of Kaupthing, Singer & Friedlander (KSF) and to transfer around £2.5 billion in retail deposits to ING, the Dutch savings bank now facing trouble of its own.

If the case proceeds, it would threaten to expose the frantic scenes at the Treasury two weeks ago as officials scrambled to protect thousands of British savers with deposits in Iceland's struggling banks.

Richard Beresford, a partner at Grundberg Mocatta Rakison, the City law firm acting for Kaupthing, said today that the Treasury's decision to put KSF into administration triggered the panic that caused its parent in Iceland to collapse.

Mr Beresford said that the Government had rushed into the decision by mistakenly "lumping all the Icelandic banks together", and that Kaupthing would not otherwise have failed.

"The unfortunate effect of the Government's decision may have been that it produced the sort of problem they were seeking to avoid," Mr Beresford said.

The Treasury seized KSF on October 8 and transferred around 160,000 depositors from Kaupthing Edge, its retail arm, to ING Direct. The following day, Kaupthing, unable to meet its obgliations to creditors and therefore technically in default, was taken over by the Icelandic Financial Services Authority, joining two of the country's other biggest banks, Landsbanki and Glitnir, under state control.

Mr Beresford said that Kaupthing has a strong case that the Treasury acted outside its powers under the Banking (Special Provisions) Act 2008, the legislation rushed through earlier this year to allow the Government to nationalise Northern Rock. It is also looking at seeking damages for misfeasance in public office and negligence — claims that could be worth "billions of pounds", Mr Beresford said, but that would be significantly harder to prove.

The Government has already aroused concern in legal circles that it overstepped its powers by using anti-terror legislation to freeze assets belonging to Landsbanki in a move designed to protect 300,000 British savers with deposits in the bank's internet operation, Icesave.

If Kaupthing is granted judicial review its lawyers are likely to demand access to correspondence between senior Government officials and their advisers in an attempt to show that the decision to seize KSF was politically motivated. Such disclosure could result in discussions between the Prime Minister and the Chancellor being recounted in court.

Kaupthing has up to three months to seek a judicial review. However, Mr Beresford said that a preliminary investigation — a precursor to formally filing proceedings — would probably be finished within weeks.

The bank has instructed John Jarvis, a senior Queen's Counsel at 3 Verulam Buildings, one of London's leading banking chambers, to lead the investigation.

A spokesman for the Treasury said that KSF had been put into administration in accordance with "due legal process" and added: "This move had no bearing on the status of the parent company, Kaupthing Bank hf, which is incorporated under Icelandic law.

"We are working closely with the Icelandic authorities and have made significant progress on many issues relating to the Icelandic banks in the UK."

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