An Icelandic minister launched an extraordinary diplomatic attack on the British Government as she issued a direct plea to MPs to help rebuild shattered relations between the two countries. In a letter seen by The Independent, the Foreign Minister Ingibjorg Solrun Gisladottir condemned Britain's use of anti-terror laws to freeze the assets of Iceland's crisis-hit banks and protested that the language used by British ministers had caused "devastation" in her country.

Ms Solrun Gisladottir even accused the Government of provoking attacks on Icelanders visiting Britain by stoking hostility towards her country. "Icelanders as a nation have been tarred with the same brush and are suffering real abuse in some cases," she said.

Relations between London and Reykjavik have become so strained that Iceland's Prime Minister, Geir Haarde, is threatening to sue the Government for resorting to anti-terror legislation. Iceland's Kaupthing Bank has instructed a law firm to investigate the seizure of its UK subsidiary, Kaupthing Singer and Friedlander (KSF).

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Iceland's key interest rate was raised yesterday by a huge 6 per cent to a record 18 per cent in a bid to meet the requirements of a £1.28bn rescue loan by the IMF. When the scale of Iceland's crisis emerged, Gordon Brown condemned the behaviour of its government as "totally unacceptable". Officials from both sides have sought a solution but Ms Gisladottir's letter confirms the gulf between the countries.

Abandoning diplomatic niceties, she said: "We are doing our best to sort out the situation in talks with the UK Treasury. But we have been shocked by the measures taken by the UK Government. It has been very difficult for Icelanders to understand how anti-terrorist legislation can be used by a close ally and friendly neighbour. It makes no sense to see an Icelandic company listed next to al-Qa'ida and the Taliban on the Treasury website."

She said Mr Brown's actions had made business between the two countries "extremely difficult", adding: "It is my hope that we will be able to rebuild the very positive and long-standing relations between the UK and Iceland."

The Labour MP Austin Mitchell, who chairs the all-party British-Icelandic parliamentary group, urged David Miliband, the Foreign Secretary, to resolve the impasse. "Our government has been heavy-handed and abrupt in dealing with the Icelandic problem," he said. "We should have helped but we bullied and made the problem worse." The Icelandic government said that Britain had "set a tone that is difficult to get away from".

The Foreign Office insisted there were still strong ties between the two Nato allies but said anti-terror laws could be invoked when Britain faced a "threat to its financial security". The Chancellor, Alastair Darling, ordered the seizure of Icelandic assets after he became worried by emergency loans made to the island's banking system by Iceland and Sweden's central banks.

On 7 October, the Financial Services Authority seized Heritable, an offshoot of the Landsbanki bank. A day later it took control of Kaupthing, Singer and Friedlander and Landsbanki's assets in the UK. Mr Darling claimed the move was necessary to protect British depositors. He told the BBC that the Icelandic government had "told me they have no intention of honouring their obligations" – but Reykjavik has strenuously disputed this claim.

Kaupthing's case could involve a £2bn High Court damages claim against Mr Brown and Mr Darling for misfeasance in public office. Richard Beresford, a partner at Grundberg Mocatta Rakison, the firm of solicitors representing Kaupthing in the UK, said the main thrust of the lender's case was that Britain wrongly applied legislation introduced to nationalise Northern Rock to seize KSF's assets. He said this was only allowed under the Banking (Special Provisions) Act if there had been a "systemic" risk to Britain's banking system.

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