“No one has tested the legal system or the documentation,” a lawyer briefed on the situation said.

The 237-page prospectus for the Nakheel bond provides little clarity. In the case of a bankruptcy by Dubai World or Nakheel, bondholders have no guarantee of “repayment of their claims in full or at all,” it said. Under Dubai law, it added, no debt owed by the ruler or government can be recovered by taking possession of the government’s assets.

A default would also pose a major new test for Dubai’s courts, which have never handled a major bankruptcy of one of the government’s own companies, lawyers and bankers said.

Unlike its neighbors, Dubai has kept its judiciary system separate from the United Arab Emirates Federal Judiciary Authority. The decisions of the Dubai courts, which are controlled by the emirate’s ruling family, can be fickle, say lawyers in the region.

For example, in order to bring a court case against a government-owned or government-run entity, a corporation or individual needs to get permission  from the government. In the prospectus for Nakheel bonds, investors are warned that “judicial precedents in Dubai have no binding effect on subsequent decisions,” and that court decisions in Dubai are “generally not recorded.”

Global issuance of Shariah-compliant bonds and loans grew 40 percent in the first 10 months of 2009 from a year ago, Moody’s Investors Services said in a November note to clients. The total amount of Shariah-compliant debt outstanding is estimated at about $1 trillion, up from $700 billion just two years ago. About 10 percent of Dubai’s $80 billion debt load complies with Shariah, bankers and analysts estimate.

Malaysia was traditionally the hub of Islamic finance, but much of this new activity has been centered around Dubai, and foreign and local law firms and banks there helped the emirate raise much of its debt. Dubai even has a school that turns students into “certified Islamic finance executives,” whose stamp of approval is required for an instrument to be deemed Shariah-compliant.

The surge in Islamic finance has led to hiring sprees at banks, and given rise to a series of new financial indicators like the Dow Jones Islamic Market index. Hoping to appeal to the Middle East’s huge sovereign wealth funds, even non-Islamic institutions have started to raise money using Islamic finance.

In October, the British Treasury drew up rules that would soon allow Britain to issue Shariah-compliant government debt. The same month, the World Bank issued $100 million in Shariah-compliant bonds.