REYKJAVIK (Reuters) - Iceland's center-right Progressive and Independence parties agreed on a coalition government on Wednesday and said they would freeze talks on entering the European Union until a referendum on whether or not to continue the process.
Both parties made big gains in elections last month where voters, fed up with years of austerity and rising debts, handed the incumbent Social Democrats the worst defeat of any ruling party since independence from Denmark in 1944.
As expected, progressive leader Sigmundur Gunnlaugsson will become prime minister in the new government, becoming one of Iceland's youngest leaders at 38.
Independence Party leader Bjarni Benediktsson will be the new finance minister of a country which is still recovering from a 2008 banking crisis.
"The EU talks will be stopped until a referendum has been held on the issue. When the referendum will be held has not been decided," Gunnlaugsson told a news conference.
He said a special report would be presented to parliament on how the EU talks have been going and a report on the situation within the EU itself.
The two parties have traditionally been among the most skeptical about Iceland joining the EU, with the Social Democrats the most in favor.
Immediately after the bank crisis, support for EU membership rose as some saw it as a way to bring economic stability in the future. But Europe's sovereign debt problems reduced interest in joining a bloc with which Iceland already has good trade ties.
The party leaders also presented a pact where they stated the government planned to use the assets of the estates of the failed banks to help cut the debt of households, a pressing issue which is seen as having held back the recovery.
Iceland's top three banks all collapsed in the space of a few days in late 2008 after the global credit crunch stopped them being able to cope with massive debts.
The island of around 500,000 people is still saddled with capital controls, which restrict the flow of foreign currency out of the country and shield the battered crown currency.
But the controls are also blamed for hampering investment and leading to a lackluster recovery from the crisis.
Many home owners are also burdened with high levels of debt and one of the key promises of the Progressive Party during the election campaign was to find a way to reduce the debt.
But that will involve tricky talks with the claimants on the estates of the old banks, which include several U.S. hedge funds.
(Reporting by Robert Robertsson; Writing by Niklas Pollard and Patrick Lannin; Editing by Jon Hemming)