Prime Minister Geir Haarde had called early elections for May
Iceland's coalition government has collapsed under the strain of an escalating economic crisis.
Conservative Prime Minister Geir Haarde announced the resignation of his cabinet, after talks with his Social Democratic coalition partners failed.
He said he could not accept the Social Democrats' demand to lead the country.
Iceland's financial system collapsed in October under the weight of debt, leading to a currency crisis, rising unemployment and daily protests.
The economy is forecast to shrink by almost 10% this year.
The coalition between Mr Haarde's Independence Party and Foreign Minister Ingibjorg Gisladottir's Social Democratic Alliance had been under strain in recent months.
Mr Haarde told reporters on Monday: "We couldn't accept the Social Democratic demand that they would lead the government."
The Independence Party currently controls 25 of the country's 63 parliamentary seats, to the Social Democrats' 18.
The announcement comes three days after the prime minister called an early general election for 9 May, adding that he would not stand for health reasons.
The coalition government, in place since 2007, had been due to remain in place until 2011.
Ms Gisladottir said a more powerful leadership was needed.
"The government's actions in the last weeks and months were not swift enough," she said.
Her party is now expected to look for new partners to form a government until the election.
President Olafur Ragnar Grimsson said he would not give any party a mandate to form a new government until Tuesday at the earliest.
In recent months the Social Democrats had urged Mr Haarde to fire the central bank governor and move towards closer ties with Europe.
Iceland, a country of about 300,000 people, has traditionally sought to stay outside the EU.
But last month European Union Enlargement Commissioner Olli Rehn said the island might apply for membership as soon as this year.
The extent of Iceland's trouble became evident as conditions tightened in global credit markets last year.
It emerged that the country's banks, which had amassed debt during years of rapid expansion, owed about six times the country's economic output.
Money from around the world had also poured into Iceland because interest rates there exceeded 10%.
Mr Haarde's government responded to the financial collapse by nationalising leading banks. It also negotiated about $10bn in loans with the International Monetary Fund and donor countries.
Commerce Minister Bjorgvin Sigurdsson resigned on Sunday citing the pressures of the economic meltdown.