Iceland bank crisis could cost 85 pct of GDP

* Iceland banking crisis could end up costing country 1.1 trillion Iceland crowns .

* Government debt, budget deficit to rise

* Iceland hires lawyers for possible action vs British govt.

By Omar Valdimarsson

REYKJAVIK (Reuters) - Iceland's Prime Minister Geir Haarde said on Thursday the total cost of the country's banking crisis could amount to 1.1 trillion Icelandic crowns ($9.40 billion), or 85 percent of 2007 gross domestic product.

According to a statement released by the prime minister's office, Haarde told parliament the 2009 budget deficit could be as high as 10 percent of economic output, pushing gross debt -- which stood at 29 percent of GDP at the end of 2007 -- above 100 percent by the end of next year.

In a separate statement, Haarde said Iceland was still looking at possible legal action against Britain after a conflict over billions of crowns in frozen deposits in Icelandic financial institutions.

"As I have said before, my government has retained the services of a British law firm to investigate where there are grounds for legal action against the British government because of its absurd decision to apply terrorist legislation against Icelandic interests in the UK," Haarde said.

The island nation's financial system has all but collapsed since the country was forced to take over three of its biggest banks this month. Some fear the economy will contract as much as 10 percent next year.