The government will take legal action in the international courts to recoup billions of pounds paid to British savers when the Icelandic banking system collapsed in 2008.
Voters in Iceland used a referendum to reject for a second time a settlement to repay the British and Dutch governments £3.5bn over a 30 year period.
The Icelandic prime minister described the result as the "worst option" - and ministers here have pledged to continue their efforts to reclaim the money.
Danny Alexander, Chief Secretary to the Treasury, said: "It is obviously disappointing that it seems that the people of Iceland have rejected what was a negotiated settlement."
Mr Alexander said it looks like the process will now end up in the courts.
"Of course we respect the will of the Icelandic people in this matter and we are going to have to now go and talk to the international partners with whom we work, not least the government of the Netherlands," he told the BBC.
Iceland's state television said almost 60 per cent of voters had rejected the agreement, based on results from five out of six voting districts, including the capital Reykjavik.
Many voters were against taxpayers footing the bill for irresponsible bankers.
Iceland's prime minister, who has predicted a 'no' vote would cause economic uncertainty for at least a year or two, did not say whether the government planned to resign.
"We must do all we can to prevent political and economic chaos as a result of this outcome," she said.
Economists have said the uncertainty is hurting efforts to drag Iceland out of recession, end currency controls and boost investment
"The worst option was chosen. The vote has split the nation in two," Prime Minister Johanna Sigurdardottir told state television, saying it was fairly clear the 'no' side had won.
The debt was incurred when Britain and the Netherlands compensated their nationals who lost savings in online "Icesave" accounts owned by Landsbanki, one of three Icelandic banks that collapsed in late 2008.
Sigurdardottir said Iceland would now defend its case before the court of the European trade body overseeing Iceland's cooperation with the EU, the EFTA Surveillance Authority (ESA). Economists have said this route could be much costlier.
Economic Affairs Minister Arni Arnasson told the television he would be in touch next week with ESA, which said last year, in a first stage in legal proceedings, that Iceland should pay compensation to Icesave depositors.
Britain and the Netherlands both said they were disappointed by the vote.
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