Just a few short years ago, Iceland had much to be proud of. The good times were rolling so fast that one expected the country's almost round-the-clock summer daylight to last all year. Business was booming, society overfed, and the capital, Reykjavik, was in vogue as a travel destination for rich revellers, gastronomes and culture lovers.

Iceland is a country of dramatic natural beauty: lunar landscapes, spouting geysers, sheer glaciers and craggy volcanic rock formations; an impressive but inhospitable isle floating in mid-Atlantic isolation. When, in 2007, it topped the UN's Human Development Index for its high standard of living, literacy and life expectancy, the tiny community of 310,000 felt they had proved their educated, hard-working and resilient character on an international scale.

The previous year, America had abandoned its long-standing naval air station at Keflavik. Symbolically, the move set Icelanders free from more than seven centuries of foreign domination, first as a Norwegian and then a Danish colony, and for the past 65 years, less formally, under the wing of the US.

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"The Vikings" had risen again, and this is the admiring title the country bestowed upon the small group of aggressive businessmen whose high-risk investing bloated the island's economy to 10 times its GDP, buying up chunks of the British and Continental European high streets in the process. French Connection, Debenhams, Karen Millen, Oasis, Warehouse, Mappin & Webb, Hamleys and many more fell into Icelandic ownership. So did West Ham United football club. When Icelanders visited Copenhagen, they would strut into its smartest department store to buy expensive fashions from "their" shop. Like many British chains, it too was owned by the "Viking" Jon Asgeir Johannesson's Baugur group: one in the eye for the mother country.

Few stopped to consider, let alone fret over, whether their swift financial ascent would end in an equally steep plunge into oblivion. They were too busy flying to Barcelona for dinner, opening smart boutique hotels, investing in art, planning massive public buildings and buying Range Rovers and Audi Q7s – Iceland is one of the top car-owning countries in the world.

In October, Iceland's three main banks were nationalised and declared bankrupt. Overnight, any Icelander – and there were many – who had bought these status vehicles or invested in luxury new properties with a foreign loan found the value of their purchases plummeting as repayments soared. The currency, the Krona, fell to one quarter its value before trading in it was suspended. Thousands of hard-working couples nearing retirement age had placed their life savings in stocks with the Landsbanki, Glitnir and Kaupthing banks which led the crash. For many, every penny disappeared into the turbulent waters which connect Iceland with its American and European neighbours.

Frugal Icelanders have been stung too. Food and petrol costs are rising all the time and with interest rates nearing 20 per cent, domestic mortgages, even modest ones, are becoming impossible to service.

"The feeling is we are unable to look after our own affairs" says Hallgrimur Helgason, one of the country's leading novelists. "We were on our own for years and we went too far, too fast, in too little time. We behaved like children and the first thing we did when the stock market opened 10 years ago was go to London and buy toy stores and candy stores. Now we are bankrupt and there will be no money for years to come and we have more debts than we can ever repay.

"We're just like kids whose parents went away for the weekend and we trashed the entire house."

There is no word from the government yet on how it plans to repair the damage. What does that mean for the man on the streets of a country whose coffers are empty? Are we talking soup kitchens, sheltered housing and begging on street corners? Far from it. If you're as comfortable as Iceland was, the rot has its work cut out before it emerges on the surface.

The streets of the capital are clean and the people could not be more hospitable or charming. On Friday and Saturday nights, a succession of bars and clubs are packed out. Judging by the drunken state of most people, they are still spending money here.

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Iceland's troubles did reveal themselves during last week's tumultuous events. Peaceful demonstrations began in Reykjavik's main square, outside the Althing (parliament) building, had begun in October immediately after the crash. Last week they erupted in the worst riots since it became a founding member of Nato in 1949. Rocks were hurled at police and the Althing. Its windows were smashed and the building set alight. Over 130 protesters received treatment after police used tear gas to disperse the crowd, and one police officer was seriously injured.

On Friday morning, human rights campaigner and protest organiser Hordur Torfason told a chilling anecdote to illustrate the desperation many Icelanders are feeling. He had received a phone call from a man who said that four generations of his family had lost everything. "He wanted me to help them build a gallows in front of the parliament building," says Torfason. "I asked him if this was to have some symbolic significance. 'No,' came the answer. 'A member of my family wants to hang himself in public.'"

"I said I would help them but not in this way," says Torfason. "But he killed himself two days ago."

Red Cross employees and volunteers are working overtime to prepare for depression and desperation. The relief agency has expanded and is setting up support groups and activities for the unemployed. "One of the effects of long-term unemployment is depression," says the agency's Thor Gislason.

More people are attending church, he says, not just for spiritual succour, but because food is sometimes provided for a nominal charge. Soup kitchens, emblematic of Eastern bloc poverty, might be going too far. "We believe people will be too ashamed to stand in line publicly for food," says Gislason, "so we will organise activities and volunteer work where food is involved instead."

Icelanders are known for their love of good food. Now is the beginning of a month when people celebrate local cuisine by dining out on traditional dishes, but one smart restaurant with a menu featuring pickled whale blubber, whale sushi and peppered whale steaks, cod liver, pickled herring, smoked puffin breast, reindeer meat and caviar, is empty save a handful of foreign diners. Panorama, a new gourmet restaurant on the top floor of the Centerhotel Arnarhvoll, has magnificent views over Reykjavik's harbour but is equally subdued. Over in Reykjavik's 101 Hotel, owned by the "Viking" tycoon Jon Asgeir Johannesson and renowned as a favourite haunt of champagne-loving Kaupthing bankers, there are a few suits and little else.

As many as 8,000 people braved the damp cold to demonstrate last week, the largest number to attend a public protest in the history of Iceland. On Friday, the Prime Minister, Geir Haarde, who has cancer, called an election for9 May and announced that he will not run again. Yet protesters called for his immediate resignation on Saturday. The government's efforts amount to too little, too late, they say. They want parliament dissolved, a new constitution, and an investigation of those politicians they believe accountable. "Every other person is basically bankrupt," said organiser Magnus Bjorn Olafsson. "This is a revolution and we want to create a new constitution like the French did."

All walks of life were evident at the protests; well-heeled Icelanders with their designer coats and dogs were as prevalent as any other group. For many, like Gudbjorg Bjornsdottir, 47, and Runar Mar Sverisson, 50, it was their first experience of protesting. "We thought it was time we showed our support," says Bjornsdottir, "It is not enough to sit at home. We are not here for our personal situation but for the injustice."

Asgerdur Einarsdottir, 43, attended a party last week attended mostly by architects and graphic designers. She was the only one there to have a job. She works in Iceland's remaining steady industry, tourism, for a tour operator which provides visitors with thrills such as snowmobiling up a glacier or driving through lava fields.

Before the crash, Iceland was prohibitively expensive. It is now far more accessible to foreigners but the running costs of her firm, owned by the parents of Barcelona striker Eidur Gudjohnsen, have gone up 110 per cent, and they are losing the lucrative business of indulgent corporate jollies.

On Reykjavik's main shopping street, Laugavegur, bargains are suddenly to be found: in Saevar Karl, a designer department store, most items are 40 per cent off. Its manager, Tomas Tomasson, notes that Iceland is now the cheapest place in the world to buy Prada.

Everyone blames greed, political corruption and lack of financial regulation for the mess, but most know they must share responsibility. "I feel partly to blame myself," admits writer Helgason. "We admired the brashness of the Vikings and we all got carried away. We are a young and immature society."

Torfason says: "Things are bad and they will get much worse. But it is unlikely anyone will starve. There are people with no fixed address here, but none on the street; you would freeze to death. There is no call to be desperate. We are small but we have resources."

This much is true. The seas are full of fish, geothermal energy and natural gas are abundant. Oil prospecting is beginning. But there is a risk that Iceland will give its riches away in a fire sale to the same Vikings who have already half-sunk the nation once.

Iceland has survived famine, volcanic eruptions and smallpox before. Now it must confront the fact that it has been blighted by a man-made disaster.

Iceland: The facts

*Population: 313,376

* Currency: Icelandic Krona (ISK)

* Unemployment in October 2008 1.9%; January 2009: 7%. Expected to rise to 8.6% in 2010.

* Inflation: 13.1%

*Interest rates 18%

*GDP per capita in 2007: $42,000

*GDP per capita now: $39,400

*The world's eighteenth largest island, Iceland has nearly 5,000km of coastline.

*Iceland's natural resources include geothermal power and diatomite, many rivers and waterfalls are used for hydroelectricity.

*Did not gain full independence from Denmark until 1944. Granted limited home rule in 1874.

*Althing, the Icelandic parliament, is the oldest functioning legislative assembly in the world, which was established in 930.

*In 2007 Iceland was ranked the most developed country in the world by the UN.

*The Apollo 11 astronauts trained in Iceland because of the terrain's similarity to the moon.