Gordon Brown has threatened legal action against the Icelandic government as he condemned its response to the country's bank collapses as "totally unacceptable".
Scores of UK local authorities have together invested hundreds of millions of pounds in Icelandic institutions like Landsbanki, Heritable Bank and Glitnir.
The Prime Minister's comments came as the Government promised that councils facing "severe" short-term difficulties would receive assistance.
After emergency talks between town hall leaders and the Department of Communities and Local Government (DCLG), the Local Government Association said "a small number" of authorities faced specific problems.
In a joint statement, the LGA and Government said: "For those local authorities who are facing severe short-term difficulties Government and the LGA will agree an appropriate set of ways to assist.
"We will judge what's appropriate on a case by case basis but in previous situations support has included helping local authorities restructure their financial priorities, providing additional expertise and capitalisation of expenditure."
There will be another meeting next week when the positions of local authorities will be clearer.
In their statement, the Government and the LGA said there was no evidence of "recklessness" by local authorities, who had also "appeared to" have adhered to the necessary financial framework.
They added: "Many authorities have already publicly stated that any risk is not a threat to frontline services, but a small number of authorities may have specific problems."
The freezing of Landsbanki's assets would benefit local authorities, they said, while the LGA would be opening discussions with administrators of the UK subsidiaries.
Mr Brown made his comments as he visited business chiefs in Birmingham to talk about the Government's massive bail-out package that could effectively part-nationalise eight UK financial institutions.
He said: "This is a real problem because we have guaranteed the retail deposits of even Icelandic branches in Britain.
"This is a problem that has been caused by Iceland. It is totally unacceptable behaviour. I have talked to the prime minister of Iceland.
"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 a 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.