Iceland's president refused on Tuesday to sign into law a bill to repay more than $5 billion lost by savers in Britain and the Netherlands, forcing the issue to a referendum and stirring fresh turmoil in the crisis-hit country. President Olafur Grimsson's rejection of the unpopular bill put aid from international lenders and his country's aspirations to join the European Union in serious jeopardy, analysts said.

A Finnish official said the decision was likely to delay a loan of 1.8 billion euros from Nordic countries. Continued financial assistance is vital in the wake of the north Atlantic island's economic meltdown.

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 requires the issue to be put to a public vote if the president refuses to sign.

It has steadily become more apparent that the people must be convinced that they themselves determine the future course, Grimsson told a news conference.

The Dutch Finance Ministry said it was very disappointed and would demand an immediate explanation. The British Treasury said it would consult with Iceland and take up the matter in the European Union, where Britain and the Netherlands have a veto over Reykjavik's membership bid.

The cost of insuring Icelandic debt against default was little changed, with five-year credit default swaps at 428 bps after the news, compared with 427 on Monday.

BIG SURPRISE

After weeks of heated debate, Iceland's parliament late last month narrowly passed the bill in a move seen as a boost to the country's hopes of swift EU entry and of getting its shattered economy back on track.

But nearly a quarter of the nation's 240,000 voters signed a petition asking the president to refuse to sign the bill and force a referendum on the fiercely debated issue.

This is a big surprise ... it's very market negative, said Petter Sandgren, head of money markets at SEB.

I assume it would affect the IMF package.

The Icesave deal is deeply unpopular with the Icelandic population and there is widespread feeling that taxpayers are being left to foot the bill for mistakes made by financial firms operating under the watch of other national regulators.

Critics say the bill would lumber Icelanders with an extra debt burden equivalent to 40 percent of gross domestic product or $18,000 per citizen, including interest payments.

Iceland's main banks -- Kaupthing, Glitnir and Landsbanki, operator of the high-yield Icesave accounts -- all imploded as the global financial crisis left them unable to service the huge debts run up in the course of a rapid expansion overseas.

The financial meltdown caused trade in the Icelandic currency to collapse and spawned a withering recession that has left the volcanic island nation dependent on billions of dollars worth of aid from the International Monetary Fund and others.

IMF ON HOLD?

The row with Britain and the Netherlands over compensating savers with Icesave accounts held up initial IMF payments and made it difficult for the country to relax exchange controls put in place to shelter the currency.

You can't hold a referendum in three days and this issue is pressing. The IMF will have to put on hold payment of any future tranches of aid until we have a 'yes' vote, Danske Bank analyst Lars Christensen said.

British Finance Minister Alistair Darling warned on Monday that Iceland would face problems if it did not follow through on the agreement struck with its European neighbors.

An agreement has been reached with us and the Dutch government and I really think it should be implemented because otherwise I think it will just make things far more difficult than they need be, he said.

Britain and the Netherlands have veto power over Iceland's EU membership bid and could block the entry negotiations.

(Additional reporting by Simon Johnson and Nick Vinocur; writing by Niklas Pollard, editing by Paul Taylor)

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