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More than 100 councils have invested millions of pounds each in Iceland’s banks – three of which are now under government control with little prospect of compensation. 

Police authorities and charities have also lost millions and private firms are believed to have invested up to £11billion.

A spokesman for the Local Government Association said: “If this money is lost, one way or another these local authorities are going to have make up the cash.”

Tony Travers, local government expert at the London School of Economics, forecast that councils would have to raise bills. 

“Something has got to give. If it’s not council tax then it will be service cuts. What could happen is councils borrow money. It takes 25 years of increased council taxes at possibly five per cent to pay that off,” he said.

Paying off the loan would put around £65 a year on the bill of an average home.

Last night former Deputy Prime Minister John Prescott came under fire after it was revealed that he had instructed councils to chase big returns on their cash in places like Iceland. Tory local government spokesman Eric Pickles accused Mr Prescott of creating the crisis as his “last gift to local government”.

The Tories released 2004 guidance from Mr Prescott telling councils that they should pay as much attention to rates of return as to how safe their money would be. 

Mr Pickles said: “Alistair Darling needs to provide reassurance to the public that they won’t see their council tax bills rise or local services cut as a result of this crisis.”

One council in London is said to be facing difficulties paying staff this month because £20million of its funds have been frozen in an Icelandic bank. The amount is equivalent to around five per cent of all money paid in council tax last year.

A meeting between the Treasury and the Local Government Association broke up last night without a guarantee from Whitehall to make good councils’ losses.

All that emerged was a promise that councils facing “severe” difficulties after investing in collapsed Icelandic banks would receive “appropriate” assistance.

Mr Brown last night threatened to sue the Icelandic government in an echo of tensions during the Cod War of the 1970s.

He said: “We are taking legal action against money that has been moved out of Britain into Iceland. We are trying to freeze the assets of Icelandic companies here. It is the responsibility of the Icelandic government, but we recognise also that there are issues for local authorities and we are talking to local authorities today to see what we can do to help them. 

“This is entirely the responsibility of the Icelandic authorities. We will endeavour to get the money back from the Icelandic authorities who have let people down.” 

The Association of Police Authorities said that 15 forces had invested £95.72 million with Icelandic banks. 

British charities have “in excess of £30million” in stricken accounts, according to the Charities Aid Foundation.

Tory leader David Cameron said: “The Government has got to get to the bottom of how bad this problem is. Then we have to work out how we can help.”

Liberal Democrat local government spokesman Julia Goldsworthy, said: “The real issue here is making sure that frontline services like fire and policing, social care and transport are protected.”

Last night the GMB union called for an inquiry into the fiasco and demanded to know why councils had kept so much money. National Secretary Brian Strutton said: “There are some serious questions that need to be answered.”

Among the biggest losers are large county councils such as Kent which has £50million in Icelandic banks, Norfolk with £32.5million and Dorset with £28.1million. But smaller authorities have also been hit. Cheltenham Borough Council has lost £11million, around 12 per cent of its annual budget. 

Iceland’s once-sleepy banking sector offered some of the highest interest rates on the market. But with the global supply of money freezing, those banks were left high and dry. 

Glitnir Bank and Singer & Friedlander – the UK arm of Kaupthing, Iceland’s biggest bank – have both been nationalised while Landsbanki, the biggest borrower, is in administration.

Iceland’s government has so far not said how much money, if any, is likely to be salvaged from the collapse.

One local authority, Brighton and Hove City Council, said it suspended transactions with Singer & Friedlander a year ago over concerns about the security of its money.

Finance councillor Jan Young said: “Our watchword is caution. We’re very aware of our responsibilities in managing taxpayers’ money, and are very careful both about who we invest with and how much we invest.” 

Mr Brown used anti-terror laws to freeze an estimated £4billion of assets belonging to private savers in Landsbanki, which owns failed internet bank Icesave. 

Iceland, whose president Olafur Ragnar Grimsson underwent heart surgery this week because of the crisis, criticised the move against a “friendly” country.

Yesterday, the human cost of the collapse emerged after The Naomi House children’s hospice in Sutton Scotney, near Winchester, Hants, said it has £5.7million of deposits at risk after investing with Singer & Friedlander.

A hospice spokesman said it had contacted the Government to see whether it would be reimbursed. 

The spokesman said that although it was a “significant sum”, hospice services were not under threat.