Anti-terrorism powers were used yesterday to recoup money owed to UK depositors in a failed Icelandic bank in a move that risked sending relations with Reykjavik to their lowest since the 1970s "cod wars".
UK taxpayers are likely to pay out at least £2.4bn as part of a £4.6bn scheme to compensate hundreds of thousands of account holders at Landsbanki, the Icelandic lender, according to Whitehall sources.
Alistair Darling, chancellor, offered a blanket guarantee to UK retail depositors with money placed in Icesave, a failed internet bank owned by Landsbanki. But wholesale depositors in failed Icelandic banks - including dozens of local authorities and some universities - were offered no immediate support.
Some councils have lost sums of up to £40m, prompting the Local Government Association, which represents about 400 councils, to urge Mr Darling to extend protection to town halls.
The Conservatives said the black hole was a threat to services and could increase council tax bills. "Government needs to stop dithering and clear up this uncertainty," said Eric Pickles, shadow local government secretary.
Gordon Brown unveiled "legal action against the Icelandic authorities" to recover depositors' money, as the tone deteriorated to its lowest level since fishing and coastguard vessels clashed over cod stocks in the north Atlantic in 1976.
The chill came as Geir Haarde, Iceland's prime minister, expressed disappointment at the refusal of western allies to help prop up the krona and said he had to find "new friends" in the form of Russia, which is considering a €4bn (£3bn) loan.
However, officials from both the UK and Iceland later said that relations were not as bad as the political rhetoric implied.
The Treasury expected Iceland's depositor compensation scheme to cover about £2.2bn of the £4.6bn owed to about 300,000 Landsbanki depositors, with £1.4bn coming from the UK industry financial services compensation scheme and the remainder from the government.
Public cash would be needed to cover the industry share, the Treasury added, as the compensation scheme lacked sufficient money. It would try to recoup the taxpayers' contribution later from the proceeds of the sale of Landsbanki's estimated £7bn UK assets.
Treasury officials wanted to ensure wholesale creditors were treated "fairly". But Mr Darling told MPs that local authorities - unlike individual depositors - were "informed investors".
Lawyers said the Treasury's unprecedented use of anti-terror powers to freeze Landsbanki's estimated £4bn UK financial assets could create knock-on problems for other institutions with which the failed lender was doing business.
The freezing order was issued under the 2001 Anti-Terrorism, Crime and Security Act that was passed after the September 11 attacks the same year.
Reporting by Tom Braithwaite in Reykjavik and Alex Barker, Michael Peel and Jimmy Burns in London
Two local authorities in the English county of Hampshire have a total of £3 million invested with troubled Icelandic banks it was revealed today. Rushmoor Borough Council has a £2 million investment with Glitnir, while  revealed it has £1m invested with Landsbanki subsidiary Heritable.

Both district councils said the money accounts for only a small proportion of their total investments: 5% in the case of Rushmoor and 3% for Winchester.  This is part of a nationwide problem, as over £550 million has been invested in Icelandic banks by British local authorities, with over 70 councils affected.

The news came after Icelandic Internet bank Icesave suspended all 300,000 of its UK customer accounts earlier this week as a result of the worsening global financial crisis.  Personal customers of Icesave and other failed banks from Iceland have had the security of their savings guaranteed, but the same protection does not apply to the local government accounts.  The Local Government Association (LGA) is campaigning for the protection to extend to them as well, and this call was backed by Winchester City Council.