"Based on new legislation, the Icelandic Financial Supervisory Authority (FME) proceeds to take control of Kaupthing to ensure continued commercial bank operations in Iceland," the authority said in a statement on Thursday.
Iceland's stock exchange announced a two-day suspension in trading shortly after the announcement.
The move to nationalise Kaupthing comes amid continued volatility on global stock markets, which was originally prompted by a lack of liquidity between competing banks.
Stocks edge higher
Falling stock markets prompted several central banks to announce cuts in their key interest rate on Wednesday, and the move appears to have had a positive effect on European markets.
London's FTSE 100 index of leading shares was up 2.12 per cent, about 45 minutes after the start of trading on Thursday, after closing with a loss of 5.18 per cent the previous day.
In early deals on Thursday, the Paris CAC 40 gained 2.14 per cent after a fall of 6.39 per cent on Wednesday, while Frankfurt's DAX 30 rose 1.37 per cent a day after it closed with a loss of 5.88 per cent.
But concerns still persist over the performance of European banks. The Icelandic government's move to nationalise Kaupthing comes after it rolled out a number of emergency financial laws to combat fears of national bankruptcy.
Iceland's economy is highly dependent on the financial sector, being nine times the size of the country's gross domestic product.
"Domestic deposits are fully guaranteed," the Financial Supervisory Authority said in an address aimed at Kaupthing customers.
Lost savings
Kaupthing's nationalisation follows the Icelandic government's decision earlier this week to take control of Landsbanki and Glitnir, the country's second- and third-largest banks.
The British government said on Wednesday that it is planning to sue Iceland over the loss of deposits held by thousands of Britons in IceSave, the internet banking operation of Landsbanki.
But Geir Haarde, the Icelandic prime minister, said that there is a "good probability" that the total assets of Landsbanki will cover the deposits in IceSave.
"The government of Iceland is determined not to let the current financial crisis overshadow the long-standing friendship between Iceland and the United Kingdom," he said in a statement.
Highlighting the global nature of the credit crisis, the British government announced on Wednesday that it would partially nationalise eight leading banks in an attempt to encourage them to restart interbank lending and thus reinvigorate the wider economy.