UPDATE 1-Iceland bank crisis could cost 85 pct of GDP

* Iceland banking crisis could end up costing country 1.1 trillion Iceland crowns ($9.4 billion).

* Government debt, budget deficit to rise

* Iceland hires lawyers for possible action vs British govt.

(Adds background, PM comment, legal dispute)

By Omar Valdimarsson

REYKJAVIK, Oct 30 (Reuters) - Iceland's Prime Minister Geir Haarde said on Thursday the total cost of the country's banking crisis could amount to 1.1 trillion Icelandic crowns ($9.40 billion), or 85 percent of 2007 gross domestic product.

According to a statement released by the prime minister's office, Haarde told parliament the 2009 budget deficit could be as high as 10 percent of economic output, pushing gross debt -- which stood at 29 percent of GDP at the end of 2007 -- above 100 percent by the end of next year.

In a separate statement, Haarde said Iceland was still looking at possible legal action against Britain after a conflict over billions of crowns in frozen deposits in Icelandic financial institutions.

"As I have said before, my government has retained the services of a British law firm to investigate where there are grounds for legal action against the British government because of its absurd decision to apply terrorist legislation against Icelandic interests in the UK," Haarde said.

The island nation's financial system has all but collapsed since the country was forced to take over three of its biggest banks this month. Some fear the economy will contract as much as 10 percent next year.

Unlike countries such as Britain or the United States, Iceland has been unable to bail out its banks due to the size of the financial sector in relation to the country's GDP.

After an overseas acquisition spree over the last few years, Icelandic banks owed more than $60 billion to foreign lenders.

Iceland's GDP in 2007 was around $11 billion.

PAINFUL MEDICINE

Haarde warned that Icelanders, who had enjoyed one of the highest standards of living in the world, faced a period of painful adjustment.

The central bank this week as policy-makers ratcheted up interest rates by a massive 6 percentage points to a record high 18 percent.

The hike came at the behest of the International Monetary FundF, under a preliminary deal that could result in its lending $2 billion to the nation of just 300,000 people.

Iceland is seeking $4 billion more from, among others, its Nordic neighbours and Russia.

Haarde repeated that there was reason to hope that interest rates would go down soon as inflation -- which was running at 15.9 percent in October because of currency weakness -- decreased and the currency stabilised.

The crown was trading on Thursday at around 220 per euro outside Iceland EURISK=D3 compared with Thursday's central bank fixing at 153 ICEX.

Although the IMF and tiny neighbour the Faroe Islands, a Danish province, have offered help, Haarde said Iceland was still at odds with Britain, which froze Icelandic banks' assets to protect British depositors.

He said Iceland hopes for a amicable solution to the problem, which relates to around 4 billion pounds ($6.61 billion) of deposits in Icesave accounts in Britain that were offered by now defunct financial firm Landsbanki.

"But the Icelandic government has been very clear we will never agree to terms that devastate the Icelandic economy. The British must understand this." (Reporting by Omar Valdimarsson in Reykjavik via Stockholm newsroom)