The Icelandic Government is facing a legal challenge to its restrictive student loans regulations.

The European Free Trade Area (EFTA) Surveillance Authority considers that the rules break European Union freedom-of- movement rules. These have to be applied in Iceland for EU and EFTA members because Iceland is in the European Economic Area (EEA), where many EU laws apply.

Icelandic legislation applies stringent criteria to applicants for student loans who are planning to work while studying or to attend courses directly related to a previous profession. They must be resident in Iceland and have lived there two years ahead of their application, or three out of the previous ten years.

The surveillance authority has based its threatened legal action on its view that the residence requirements indirectly discriminate against migrant workers and their dependent family members.

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The authority said: "Even if the residence requirements apply to Icelandic nationals also they are indirectly discriminatory because, in practice, they are more easily met by Icelandic nationals than by nationals of other EEA states." This includes all EU citizens.

Iceland government lawyer Valur Arnason said that ministers were considering whether to fight the case or to liberalise their regulations.

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But he warned about the effect on Iceland if there were a free-for-all.

EFTA court rulings are binding precedents in the EU.

At present, the UK does not impose residence requirements on "migrant worker" students who want to secure British student loans.