The British and Dutch governments said they were disappointed with the result of a referendum on Saturday (9 April) in which almost 60% of voters opposed a repayment deal, the second time the Icelandic public has snubbed an agreement.
The debt was incurred when the two countries compensated their nationals who lost savings in online 'Icesave' accounts owned by Landsbanki, one of three Icelandic banks that collapsed in late 2008, triggering economic meltdown in the country of 320,000 people.
Britain's Independent newspaper said the 'no' vote would cause friction with Britain and the Netherlands and increased the chances that one or the other, both European Union members, might veto Iceland's bid to join the bloc.
Britain's Chief Secretary to the Treasury, Danny Alexander, said he was disappointed Icelanders seemed to have rejected what was a negotiated settlement.
"It now looks like this process will end up in the courts," he told BBC television over the weekend.
Dutch Finance Minister Jan Kees de Jager said: "This is not good for Iceland, nor for the Netherlands. The time for negotiations is over. Iceland remains obliged to repay. The issue is now for the courts to decide."
The issue will now be settled by the court of the EFTA Surveillance Authority (ESA), the European trade body overseeing Iceland's cooperation with the European Union.
"My estimate is that the process will take a year, a year and a half at least, Finance Minister Steingrimur Sigfusson told a news conference after Saturday's vote.
Economists have said the court route could be much costlier and Iceland will face delays ending currency controls, boosting investment and returning to financial markets for funding.
Government's future in doubt
The Financial Times said the case highlighted flaws in European cross-border banking rules and raised questions over who is legal and morally responsible for foreign deposits held by domestic banks when a country's financial sector goes bust.
"It has also raised doubts over the future of Iceland's centre-left government, led by Johanna Sigurdardottir, prime minister, who has staked her credibility on resolving the Icesave dispute and pushing for EU membership."
Iceland's centre-left coalition government said it would not resign despite the defeat.
"The government will emphasise maintaining economic and financial stability in Iceland and continuing along the path of reconstruction which it began following the economic collapse of 2008," it said in a statement.
It said a fresh round of talks on further funding from the International Monetary Fund, which led a bailout for the island, would be delayed by several weeks, but that it had enough foreign exchange reserves to cover debts maturing this year and next.
(EurActiv with Reuters.)