UK Prime Minister Gordon Brown has condemned Iceland's handling of the collapse of its banks and its failure to guarantee British savers' deposits.
He said its action were "effectively illegal" and "completely unacceptable".
Mr Brown's government has frozen all UK-held assets of the Icelandic bank Landsbanki after it collapsed.
Iceland's prime minister Geir Haarde said it was "not very pleasant" to learn that anti-terror laws were being used to deal with the company.
Landsbanki, one of many banks hit heavily by the global credit crunch, was taken over by the Icelandic government and declared insolvent on Tuesday.
The 300,000 UK customers of its subsidiary IceSave were unable to access their accounts.
'Further action'
UK Chancellor Alistair Darling later announced that all UK savers affected would be protected.
But the government has not yet offered the same for more than Ј900m known to have been invested in Icelandic banks by UK councils, police and transport authorities.
In an interview with BBC political editor Nick Robinson, Mr Brown said the government was talking with local authorities about what could be done and intended to recover as much money as possible.
He added: "What happened in Iceland is completely unacceptable. I've been in touch with the Icelandic prime minister. I said this is effectively illegal action that they have taken.
"We are freezing the assets of Icelandic companies in the United Kingdom where we can. We will take further action against the Icelandic authorities wherever that is necessary to recover money."
He added: "This is fundamentally a problem with the Icelandic-registered financial services authority - they have failed not only the people of Iceland, they have failed people in Britain."
Mr Haarde, asked if he felt there was a crisis in relations between Britain and Iceland, said: "I thought so for a few minutes this morning when I realised that a terrorist law was being applied against us.
"That was not very pleasant. I'm afraid that not many governments would have taken that very kindly, to be put in that category and I told the chancellor that we were not pleased with that."
But he said he had cleared up a number of issues with Mr Darling.
(BBC)
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