REYKJAVIK (Reuters)– Iceland's president rejected a bill to repay Britain and the Netherlands more than $5 billion their savers lost when Icelandic banks collapsed, forcing a referendum on the issue and threatening vital economic aid.

President Olafur Grimsson's refusal to sign the unpopular Icesave bill into law yesterday 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 percent of voters oppose the bill.

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.

Britain warned that if Icelandic voters rejected the bill, the north Atlantic island with a population of just 350,000 faced financial isolation.

"The Icelandic people ... would effectively be saying that Iceland does not want to be part of the international financial system, " Financial Services Minister Paul Myners said.

That would mean losing access to international funding and being shunned as a business counterparty, he 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.

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.

The president's move plunged the country into fresh political turmoil.

"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.

"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 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.