By Marc Jones and Ragnhildur Sigurdardottir

LONDON/REYKJAVIK (Reuters) - A group of U.S. funds battling with Iceland after it froze $1.4 billion of the government's bonds they own are limbering up for a legal fight if Reykjavik continues to stonewall efforts at a deal.

While the players and amounts of money involved mean the situation is unlikely to develop into an years-long Argentina-style standoff, it is overshadowing Iceland's comeback from one of the world's most extreme banking crises.

A few weeks ago it took a big step in dismantling its 8-year old capital controls and the smooth progress so far has earned the country a double-notch credit rating upgrade and has been driving up its currency <ISKUSD=R>.

One headache, however, is that it remains deadlocked with funds Autonomy Capital, Eaton Vance, Loomis Sayles and Discovery Capital Management -- whose frozen bonds are worth roughly 10 percent of Iceland's annual economic output -- after they spurned what they saw as low-ball government offer to unlock them back in June.

Two of the funds, Autonomy and Eaton Vance, have filed a complaint to the European Free Trade Association (EFTA) in Brussels which is ongoing, saying that the quarantining of their bonds amounts to a discrimination against foreign investors. Autonomy has made a separate approach to a court in Iceland.

Iceland rejects the claims saying that some domestic investors are also affected and that the moves are necessary to allow a smooth lifting of capital controls, so barring any sudden change of tack the situation looks set to escalate.

"Offshore investors (the U.S funds) have made a concerted effort dating back to 2015 to provide multiple solutions (to the deadlock)," one of the funds' leading lawyers in EFTA case, Morrison & Foerster's Gary Lee told Reuters.

"The Icelandic government has refused to engage, and has instead chosen a discriminatory path that will in the short and long-term only harm the Icelandic economy and the Icelandic people."

An EFTA spokesperson said the funds' deadline to clarify the next stage of the complaint was Sept. 20 but a spokesman for Iceland's central bank played down the threat from any formal legal action that followed.

"The Icelandic authorities have made a careful analysis of the legal implications of the strategy for lifting capital controls and are confident that the strategy is fully consistent with both domestic law and Iceland´s international obligations," the central bank spokesman said.

The finance ministry added: "Particular attention has been given to ensuring that this bill of legislation does not conflict with the EEA (European economic area) Agreement."


But the central bank is also keeping the hopes of some kind of deal just about alive. The head of central bank said when the lifting of capital controls was announced last month that the 'offshore Krona' issue could be revisited next year.

"The lifting of controls on these off-shore investments is a matter of sequencing," the spokesman added.

However, "As these (bonds) are fairly liquid assets and the total claims amount to roughly 10 percent of Iceland´s GDP it would be too risky to lift restrictions on the offshore investments at the same time as the focus turns... toward lifting controls on local households and corporates."

For now it leaves the funds in limbo. Not only is ending years of capital controls a delicate process, but Iceland is holding elections next month which is dominating the government's attention.

Boston-based Eaton Vance told Reuters that they remain open negotiations though attempts at contact continue to be rebuffed.

"We are very willing and ready to work toward a solution," the company said in a statement. But "we have made a number of different proposals and have received minimal feedback from the other side."

Autonomy declined to comment, Discovery Capital Management said its policy was not to discuss specific market positions while Loomis Sayles did not respond to requests for comment.

One of the world's top sovereign debt lawyers, Cleary Gottlieb's Lee Buchheit, who represented Iceland's government in cases over its failed banks but says he is not involved in the current squabble, is skeptical of the funds' legal chances.

"I don't want to predict the outcome but it is going to be a challenge I think for these people to mount an effective legal complaint before EFTA here," he said, adding that it would also be difficult to pursue the case in another country's courts.

"Anyone challenging what they have done is going to have to say that it was unnecessary or disproportionate."

"And if you have got the IMF saying: no, what they are doing is perfectly necessary and perfectly proportional to protect their balance of payments and exchange rate, it is going to be a tough argument to make."

(This version of the story clarifies statement in paragraph 18 is company statement)

(Additional reporting by Daniel Dickson and Violette Goarant in Stockholm; Editing by Toby Chopra)