UPDATE 4-Iceland leader rejects UK, Dutch compensation bill

* President says people should decide on issue in referendum

* Decision casts doubt on further aid, EU bid

* PM questions whether president overstepped bounds

* UK says 'no' in referendum would make Iceland outcast

(Adds reaction from UK minister)

By Omar Valdimarsson

REYKJAVIK, Jan 5 (Reuters) - Iceland's president rejected a bill to repay Britain and the Netherlands more than $5 billion their savers lost when Icelandic banks collapsed, forcing a referendum on the issue and threatening vital economic aid. President Olafur Grimsson's refusal to sign the unpopular Icesave bill into law on Tuesday threw the country into a political crisis and put its hopes of joining the European Union in jeopardy.

The government said a referendum would be held as soon as possible. The outcome is highly uncertain with opinion polls showing almost 70 percent of voters oppose the bill.

Prime Minister Johanna Sigurdardottir -- who has pushed hard for a deal to repay the two countries money they advanced when British and Dutch savers lost funds in Icelandic accounts -- said her goverment was committed to honouring Iceland's debts.

Britain warned that if Icelandic voters rejected the bill, the north Atlantic island with a population of just 350,000 faced financial isolation.

"The Icelandic people ... would effectively be saying that Iceland does not want to be part of the international financial system, " Financial Services Minister Paul Myners said.

That would mean losing access to international funding and being shunned as a business counterparty, he said.

The Dutch government said it was "very disappointed" and would demand an immediate explanation.

A Finnish official said the president's action was likely to delay the next tranche of a 1.8 billion euros ($2.60 billion) loan from Nordic countries, which is part of a $10 billion International Monetary Fund-led package.

Only once in the republic's 65-year history has a president, whose post is largely symbolic, refused to sign a bill into law. The constitution says the issue must then be put to the public.

"Now the people have the power and the responsibility in their hands," Grimsson said at a news conference.

Nearly a quarter of Icelandic voters, angry at the prospect of paying debts they feel are onerous and unfair, had petitioned him to reject the bill.

Icelandic critics say Britain and the Netherlands are using their EU veto and IMF voting power to bully a small country's taxpayers into repaying savers who imprudently poured money into Icesave accounts that offered high interest rates.

CONSTITUTIONAL CRISIS?

The president's move plunged the country into fresh political turmoil.

"We are dealing here with a considerable dilemma and considerable constitutional crisis, the reason being that our constitution is weak and does not spell out clearly the role of the president," said Baldur Thorhallsson of the University of Iceland.

Parliament narrowly passed the Icesave bill last last month -- a revised version of an earlier law which Britain and the Netherlands had rejected as unacceptable.

"This is a big surprise ... it's very market negative," said Petter Sandgren, head of money markets at SEB.

"I assume it would affect the IMF package."

The cost of insuring Icelandic debt against default was little changed, with five-year credit default swaps at 428 bps after the news, compared with 427 on Monday.

Critics say the bill would lumber Icelanders with an extra debt burden equivalent to 40 percent of gross domestic product or $18,000 per citizen, including interest payments. The government disputes those figures.

Iceland's main banks -- Kaupthing, Glitnir and Landsbanki, operator of the high-yield Icesave accounts -- all imploded as the global financial crisis left them unable to service the huge debts run up in the course of a rapid expansion overseas.

The financial meltdown caused trade in the Icelandic currency to collapse and spawned a withering recession that has left the volcanic island nation dependent on IMF-led aid.

The row with Britain and the Netherlands over Icesave held up initial IMF payments and made it difficult for the country to relax exchange controls put in place to shelter the currency.

"You can't hold a referendum in three days and this issue is pressing. The IMF will have to put on hold payment of any future tranches of aid until we have a 'yes' vote," Danske Bank analyst Lars Christensen said.

The second review of the IMF-led aid programme is due to take place in the middle of January. [ID:nLDE5BK1WQ]

(Additional reporting by Simon Johnson and Nick Vinocur in Stockholm, Tarmo Virki in Helsinki, David Milliken and Sebastian Tong in London, Ben Berkowitz in Amsterdam; writing by Niklas Pollard, editing by Paul Taylor)