Landsbanki collapsed in 2008, leaving depositors of its Icesave online accounts stranded.
Britain and the Netherlands stepped in to repay savers, but it sparked a political row and the two countries sought court backing to say Iceland had failed to repay the money within time limits set by a European directive for deposit guarantee schemes.
But the European Free Trade Association court ruled today that it did not break European laws by failing to guarantee minimum levels of compensation.
All of Iceland's banks collapsed four years ago, early in the financial crisis, and the UK and Dutch governments wanted Iceland to pay them back directly and quickly.
Iceland did not comply, triggering a row between the governments and potentially complicating the island's bid to join the European Union.
The courts said Iceland did not break depositor protection laws by refusing to return the money, because the scale of its financial crisis was so big.