Iceland's president asks the Social Democrats to form a new government to lead the island nation through a financial meltdown,.

By Kim McLaughlin of Reuters

REYKJAVIK - Iceland's president called on the Social Democratic Alliance to form a new government with the backing of opposition parties to lead the island nation through a financial meltdown.

In the face of mounting public anger over a financial crisis that has devastated Iceland's economy, former prime minister Geir Haarde resigned on Monday after his Independence Party's coalition with the Social Democrats collapsed.

The SDA, with 18 of 63 parliamentary seats, is the second biggest party and has long been at odds with the Independents over whether to seek membership of the European Union.

President Olafur Ragnar Grimsson told reporters he had asked Ingibjorg Gisladottir, foreign minister under Mr Haarde and head of the SDA, to take the lead on forming a government.

"I have decided to ask the leaders of the Social Democratic Alliance and the Left-Green party to engage in conversation about forming a new minority government backed by the Progressive Party," Mr Grimsson told reporters at his residence.

Ms Gisladottir said she hoped her talks to form a coalition with the Left-Green Party would be completed before the weekend.

"I thank the president for his trust and we will try and come to a quick conclusion in our discussions, preferably by the weekend," she told reporters.

Ms Gisladottir, who recently had treatment for a benign brain tumour, on Monday appeared to rule herself out from becoming prime minister, saying she planned to take a leave of absence for one or two months.

Ms Gisladottir proposed Social Affairs Minister Johanna Sigurdardottir as a candidate for prime minister.

The announcement came after Mr Grimsson met Ms Gisladottir and Steingrimur Sigfusson of the Left-Greens. He held individual talks with both leaders late on Monday.

The global financial crisis hit the North Atlantic nation in October, ending a decade of rising prosperity by triggering a collapse in the currency and financial system.

To stay afloat last year, Iceland negotiated a $US10 billion aid package crafted by the International Monetary Fund with support from several European countries. International trade in the island's currency is effectively frozen.

Consumer confidence falls

Iceland's leaders received a fresh reminder on Tuesday of how dire economic conditions have become for the island's 320,000 residents.

Consumer confidence this month plunged to the lowest since measurements began in 2001, falling 23 per cent from the prior month and 83 per cent from a year earlier, according to pollster Gallup.

The political crisis has given Iceland another dubious milestone. It is now the first world government to fall as a direct result of the global economic crisis.

The Left-Greens and the Social Democrats disagree on a number of issues including accession to the European Union, which Ms Gisladottir's party supports.

Left-Green leader Mr Sigfusson has struck a populist note and has called for negotiations to be reopened with the IMF to make the reforms better suited to Icelandic needs.