Oct. 22 (Bloomberg) -- The U.K. Treasury is working on extending a loan to Iceland to protect British savers who have had money frozen since the government in Reykjavik seized the country's failing banks.

A delegation of Treasury and Bank of England officials is in talks with authorities in Iceland to resolve a dispute over who should compensate 300,000 British savers. Chancellor of the Exchequer Alistair Darling already has spoken to Icelandic Prime Minister Geir Haarde to resolve the spat.

``The aim of these discussions is to agree a mechanism where by the Icelandic government can honor its obligations to U.K. depositors and ensure the fair treatment of U.K. creditors,'' the U.K. Treasury said in an e-mailed statement in London today.

Iceland needs aid from the U.K., the International Monetary Fund and Nordic countries after the collapse of its banking system froze its foreign-exchange market, making it hard for importers to finance purchases. Glitnir Bank hf, Landsbanki Islands hf and Kaupthing Bank hf imploded with debts of $61 billion, 12 times the size of the economy.

The Financial Times earlier today reported that the U.K. loan would be for about 3 billion pounds, covering British depositors who put money into Icesave, the Internet arm of Landsbanki Islands hf.

Icelandic Coverage

Icelandic financial regulators usually pay the first 20,887 euros ($27,000) of any compensation for retail depositors. Amounts above that level for U.K. depositors will be paid by Britain's Financial Services Compensation Scheme up to 50,000 pounds ($82,200), and the U.K. government will pick up the tab above that limit if Icelandic authorities don't pay.

``The chancellor has already put in place arrangements to ensure that all retail depositors in the Icelandic banks will receive their money in full,'' the Treasury said

U.K. officials are seeking to make a loan conditional on money being repaid to retail depositors and on preferential treatment for other British creditors, which include more than 100 local government authorities in England and Wales.

The Local Government Association said last week that 116 councils have 858 million pounds tied up in accounts with collapsed Icelandic institutions including Kaupthing Bank hf, Glitnir Banki hf and Landsbanki Islands hf.

The Bank of England last week gave Iceland a short-term loan of 100 million pounds. That credit line is secured on assets Icelandic banks have in the U.K., which were frozen by the Treasury.

The talks with the U.K. run separately to discussions between Iceland and the International Monetary Fund.

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To contact the reporter on this story: Gonzalo Vina in London at gvina@bloomberg.net

Last Updated: October 22, 2008 08:26 EDT