President Olafur Grimsson's refusal to sign the unpopular Icesave bill into law on 5 January threw the country into a political crisis and put its hopes of joining the European Union in jeopardy.
The government said a referendum would be held as soon as possible. The outcome is highly uncertain with opinion polls showing almost 70% of voters oppose the bill.
Only once in the republic's 65-year history has a president, whose post is largely symbolic, refused to sign a bill into law. The constitution says the issue must then be put to the public.
"Now the people have the power and the responsibility in their hands," Grimsson said at a news conference.
Nearly a quarter of Icelandic voters, angry at the prospect of paying debts they feel are onerous and unfair, had petitioned him to reject the bill.
Icelandic critics say Britain and the Netherlands are using their EU veto and IMF voting power to bully a small country's taxpayers into repaying savers who imprudently poured money into Icesave accounts that offered high interest rates.
Constitutional crisis?
Prime Minister Johanna Sigurdardottir - who has pushed hard for a deal to repay the two countries money they advanced when British and Dutch savers lost funds in Icelandic accounts - said her goverment was committed to honouring Iceland's debts.
"We are dealing here with a considerable dilemma and considerable constitutional crisis, the reason being that our constitution is weak and does not spell out clearly the role of the president," said Baldur Thorhallsson of the University of Iceland.
Parliament narrowly passed the Icesave bill last last month - a revised version of an earlier law which Britain and the Netherlands had rejected as unacceptable.
London, The Hague react
Britain warned that if Icelandic voters rejected the bill, the north Atlantic island with a population of just 350,000 faced financial isolation.
Iceland would cut itself off from global financial assistance if its people vote not to compensate Britain and the Netherlands for losses caused by the collapse of Icelandic bank Icesave, financial services minister Paul Myners said on Tuesday.
Britain and the Netherlands are seeking more than $5 billion (three billion pounds) from Iceland which they paid in compensation to their domestic depositors after Icesave's failure in 2008, but Iceland's President Olafur Grimsson vetoed a parliamentary bill which approved this.
Grimsson's decision earlier on Tuesday will likely trigger a referendum in the North Atlantic island where a quarter of voters have already signed a petition calling for the deal to be scrapped.
Myners told the BBC that if Iceland voted against the deal, it would cut itself off from the global financial system and from International Monetary Fund aid for its economy, one of the worst hit by the world bank crisis.
"The Icelandic people, if they were to reach that conclusion, would effectively be saying that Iceland does not want to be part of the international financial system, that Iceland doesn't want to have access to multi-national, national and bilateral funding and doesn't want to be regarded as a safe counter-party with whom to do business," Myners said.
The Dutch government said it was "very disappointed" and would demand an immediate explanation.
A Finnish official said the president's action was likely to delay the next tranche of a 1.8 billion euros ($2.60 billion) loan from Nordic countries, which is part of a $10 billion International Monetary Fund-led package.
(EurActiv with Reuters)
