Olafur Ragnar Grimsson: "The participation of the nation in the final agreement is the only viable outcome."
Iceland's president has refused to sign a controversial bill to repay $5bn (£3.1bn) to the UK and the Netherlands.
President Olafur Ragnar Grimsson said he would instead hold a referendum on the bill, following public protests.
The legislation was designed to compensate governments forced to bail out their savers with Icesave accounts following Iceland's banking collapse.
Opponents argue the terms of the payments will unfairly hurt Iceland and its recovery from economic crisis.
Some reports say those opponents form a large majority of Icelanders - some 70% are said to be likely to vote "no" in a referendum.
Legislation to repay the money was approved by Iceland's parliament in December, but the approval of the president is also required before it can be passed into law.
It is now up to the government to decide how to proceed. It must consider whether to go ahead with a referendum or whether to withdraw the bill and reopen negotiations with the UK and the Netherlands about a repayment schedule.
The right to choose
The government has seen significant public opposition to the bill.
THE STORY SO FAR...
Early October 2008: Icelandic banks collapse forcing the government to take control
October 2008: Amid a bitter row with Iceland over who should pay, UK and the Netherlands promise to compensate their nationals who have Icesave accounts
November 2008: IMF approves $2.1bn loan for Iceland. Financial support from other countries brings total amount to $10bn.
June 2009: Iceland's new government agrees to reimburse UK and Netherlands
August 2009: Icelandic parliament approves first Icesave bill detailing payment schedule
September 2009: UK and the Netherlands reject payment terms
December 2009: Amended bill with more stringent conditions approved by parliament
On Saturday, the president received a petition calling for the bill to be vetoed, signed by almost a quarter of the country's population.
Campaigners against the bill say that the Icelandic public are being forced to pay for the mistakes of banks.
The total compensation package equates to about 12,000 euros ($17,300; £10,800) per Icelandic citizen.
Announcing the decision to hold a referendum on the bill, President Grimsson said that the Icelandic public had the right to choose.
"It is the job of the president of Iceland to make sure the nation's will is answered," he said.
"I have decided... to take the new law to the nation. The referendum will take place as quickly as possible."
In response to the decision, the Icelandic parliament, which approved the new bill last month, said the move could further tarnish Iceland's image abroad.
By Ingibjorg Thordardottir, BBC News
The president's decision to call a referendum on the Icesave law is likely to be met with mixed reactions by the Icelandic people. Many believe Iceland is paying too much back to Britain and the Netherlands and want the law courts to decide what the fair repayment amount should be.
Others say that passing the law is fundamental to Iceland's economic recovery - especially since bodies like the IMF and the Nordic countries have said they will not release much needed loans unless an Icesave agreement is finalised.
The decision is a blow to the Icelandic government which sees the legislation as a vital step in Iceland's economic recovery. It will now have to decide whether to withdraw the bill and try to renegotiate a different deal with the UK and the Netherlands or to go ahead with a referendum.
The prime minister has already made it clear that Iceland will honour its international obligations but has not said how that will be done. But the president says that a referendum is the the only way for there to be a fair and conclusive result for the Icelandic people to this drawn-out crisis.
"Uncertainty... in the formal dealings with others countries can have unforeseen, wide-ranging and potentially damaging consequences for our society," warned Johanna Sigurdardottir, Iceland's Prime Minister.
The Treasury's City Minister, Lord Myners, said he shared the Icelandic parliament's disappointment, and warned the public against voting against the bill in the referendum
"The Icelandic people, if they took that decision, would effectively be saying that Iceland doesn't want to be part of the international financial system," he said.
The Dutch government said Iceland was still "compelled to pay back the money".
BBC Brussels correspondent Dominic Hughes said the longer-term impacts of the decision could be significant for both political and economic reasons.
"It's seen as a blow to the country's hopes of a quick entry to the European Union," he said.
"In fact, the whole debate has soured feeling in Iceland towards the EU.
"It also throws doubt on further aid payments to Iceland from international lenders."
Iceland's credit status has already taken a knock. One agency that grades the fitness of a country's finances, Fitch Ratings, has put the country's debt rating at "junk" status, meaning it must pay a higher interest rate to attract borrowers who are not certain to be paid back.
The crisis in Iceland's banks forced it to borrow billions of dollars from the International Monetary Fund (IMF) - loans made on the condition that the issue of Icesave compensation would be resolved.
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