A legal showdown between the Icelandic Government and HM Treasury looked likely today as it emerged that senior officials in Reykjavik have hired one of London’s top law firms.

Lovells, one of the City's leading litigation firms, confirmed that is advising the Icelandic Government on legal issues relating to the collapse of its banking system earlier this month.

In a statement, Lovells said it has "provided advice to the Icelandic Government on English and international aspects of the ongoing financial turmoil in the country". It declined to comment further.

It is understood that Lovells has been given a broad mandate including exploring options for potential damages claims against the UK in addition to providing general advice on how Iceland should restructure its fragile banking system.

Richard Brown, a corporate partner, and Joe Bannister, an insolvency and restructuring specialist, are leading the team which includes finance, litigation, EU, corporate finance and banking lawyers.

Lovells' litigation department is best known for advising the liquidators of the Bank of Credit and Commerce International (BCCI) in their mammoth damages claim against the Bank of England, which eventually collapsed after 13 years.

More recently, it has played a key role in the ongoing litigation between Office of Fair Trading and high street banks over overdraft and penalty charges.

The UK Government is already facing the threat of legal action from Kaupthing, one of three Icelandic banks to have been nationalised in recent weeks. It has hired Grundberg Mocatta Rakison, a London firm, which is preparing an application for judicial review of the government's decision to seize control of the bank's British arm.

Kaupthing claims that the decision to seize assets belonging to Kaupthing, Singer & Friedlander caused a run on the parent bank that led to its collapse.

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