Iceland set for coalition talks after government ousted

With nearly all the ballots counted, the Independence Party took 26.7 percent of the vote and the Progressive Party 24.4 percent, both gaining 19 seats in the Althing, or parliament.

The Social Democrats were a distant third with 12.9 percent.

"Independence and Progressives teaming up in a coalition is the likely outcome," Olafur Hardarson, a political science professor at the University of Iceland said. "Other outcomes are of course possible but very unlikely."

Once a European financial centre, the windswept north Atlantic island of glaciers, geysers and volcanoes has struggled along for years after a crash that brought it to its knees in just a matter of days.

The election brings back the same parties that presided over the rise and fall. Tired by years of belt tightening, high mortgages, capital controls and unrealised promises of recovery, households lost patience with the Social Democrats.

"We are offering a different road, a road to growth, protecting social security, better welfare and job creation," said Independence leader Bjarni Benediktsson, the favourite to become the next prime minister.

"What we won't compromise about is cutting taxes and lifting the living standards of people," Benediktsson, a 43-year-old former professional soccer player, told Reuters.

The Independence party won the popular vote but earned as many seats in parliament as Sigmundur Gunnlaugsson's Progressive Party, setting the stage for a tussle between the two.

"We've seen all sorts of different forms of governments here in the past decades," Gunnlaugsson, 38, told Reuters. "Sometimes the biggest party delegates the prime minister, sometimes not."

Coalitions in Iceland are traditionally agreed in a matter of days.

"The choice seems to be clear," Benediktsson said. "We'll go into coalition with whoever we can govern with."

SHORT MEMORIES

The two parties ruled Iceland, often in coalition, between 1980 and 2009, setting in motion an economic revolution that made Iceland rich

"People seem to have a very short memory," Halldor Gudmundsson, 44, said after casting his ballot on Reykjavik's outskirts. "These are the parties that got us into the mess in the first place."

Iceland's liberalised banks borrowed heavily on cheap overseas markets and lured British and Dutch savers with high returns.

But after amassing assets worth more than 10 times Iceland's GDP, Landsbanki, Kaupthing and Glitnir collapsed in quick succession, dragging the entire country into a financial abyss in October 2008.

Property prices tumbled, unemployment soared and the currency was only saved by capital controls that locked in foreign investors indefinitely.

The Social Democrats stabilised the economy with a bailout package hailed as exemplary by the IMF. But a series of policy blunders, tax hikes, leniency toward foreign creditors and their inability to deal with household debt cost them popularity.

"Household debt is the main issue, we have very strong opinions on that and can't compromise on that," Gunnlaugsson said. "We'll work with whoever shares this passion."

Both centre right parties campaigned on offering relief to households and both said the failed bank's foreign creditors will have to accept a write-off, perhaps as much as 75 percent.

They also argued against EU membership, so the vote was also a referendum on breaking off stalled accession negotiations.

Turnout, the lowest since independence from Denmark, also reflected the sour mood among Iceland's 320,000 people.

"There's so little room to manoeuvre and they promised so much, their popularity will be gone in three months," said Egill Helgason, a political commentator for national broadcaster RUV.

The victory caps a comeback for Benediktsson.

Two weeks ago he considered resigning after low poll ratings prompted calls for him to step down as party leader.

Hailing from a rich family with many business interests, he was considered out of touch and tainted by the collapse.

He fought back with a television interview which gave voters a glimpse of his human side and propped up his party's ratings.

(Editing by Angus MacSwan)