The deal will see Iceland pay back Britain and the Netherlands for the compensation those governments paid to more than 320,000 customers who lost their savings when the online bank Icesave collapsed in late 2008. Iceland is to pay around 3.8 billion euros ($5.4 billion) over the next 14 years.
Prior to its collapse during the credit crunch Icesave had used high interest rates to attract customers from abroad.
The bill, which was approved by a vote of 33 to 30 in parliament, removes what had been seen as a barrier to Iceland's bid to enter the European Union.
Legislation unpopular with Icelanders
Although the measure was approved, ordinary Icelanders hit hard by the global economic downturn tend to resent it. A poll taken in August suggested nearly 70 percent of the population were against the Icesave deal, as the cost of compensation amounts to nearly 12,000 euros per citizen.
However, Finance Minister Steingrimur Sigfusson insisted that the deal was necessary.
"Approving the bill is the better option and will avoid even more economic damage," he said. "History will show that we are doing the right thing."
Iceland was forced to borrow around seven billion euros in aid after its top banks were brought down by the global financial crisis late in 2008.
Editor: Chuck Penfold