Kaupthing, the state-controlled Icelandic bank, has confirmed that it will sue the British Government over the Treasury’s decision to place Kaupthing’s UK arm into administration last October.

The committee in charge of Kaupthing said it had taken the decision to initiate legal action with “the full support of the Icelandic government “ in a statement released through the Icelandic Prime Minister’s office.

The announcement comes after weeks of threats from Reykjavik, which claims that the UK Government’s action contributed to Kaupthing’s collapse.

The Treasury placed Kaupthing Singer & Friedlander (KSF), the bank’s UK operation, into administration on October 8, 2008 saying it was acting to protect the interests of UK depositors.

The next day, Iceland took control of Kaupthing, the third of its major banks to fall into Government hands in a bid to stave off collapse.

The legal action will take the form of a judicial review, questioning whether the UK Government was acting within its powers when it placed KSF in administration.

If a court decides the Government acted unlawfully then the stage will be set for another legal battle in which Kaupthing can claim compensation.

Weil Gotshal & Manges, the US law firm, has been hired to bring the judicial review on Kaupthing’s behalf.

In October, the Icelandic Government hired Lovells, one of London’s top litigation law firms, to advise on issues relating to the collapse of its banking system including potential damages actions.

But yesterday the Icelandic Prime Minister said he had been advised that a direct challenge from his Government had little chance of success and it had chosen to support Kaupthing’s case instead.

The British Government seized control of KSF following a recommendation by the Financial Services Authority (FSA), the regulator, which believed the financial services group was unable to honour its obligations to customers.

The Treasury invoked new banking powers to transfer KSF's £2.5 billion of retail deposits for 160,000 customers to ING Direct, the Dutch bank.

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