The so-called Icesave bill was designed to compensate governments who were forced to bail out their citizens with accounts in the failed Icesave bank after parent Landesbanki collapsed.

The bill would have forced the Icelandic government to pay out 3.8 billion euros ($5.4 billion) to the Dutch and British governments.

Iceland's parliament narrowly approved the bill at the end of December. But more than 60,000 voters - about a quarter of the tiny country's electorate - signed a petition opposing the bill and calling for a referendum.

Icelandic President Olafur Ragnar Grimsson has now given in to the demands.

"It has steadily become more apparent that the people must be convinced that they themselves determine the future course," Grimsson said at a press conference on Tuesday. "The involvement of the whole nation in the final decision is therefore the prerequisite for a successful solution, reconciliation and recovery."

Potential voter rejection threatens EU accession

Icesave was an online savings bank owned and operated by Landesbanki, which was among the victims of Iceland's October 2008 financial meltdown. Its high interest rates attracted savers, and ultimately about 320,000 Dutch and British citizens lost money through its collapse.

Repaying the lost money has been seen as a prerequisite for Iceland's acceptance to the European Union. Rejection by voters could impede the country's membership bid.

Opponents of the bill have claimed its demands are unrealistic and that taxpayers should not be punished for the bank's mistakes. The payouts would amount to about 12,000 euros for each Icelandic citizen.

acb/dpa/AFP/AP
Editor: Nancy Isenson