Iceland's three biggest banks were nationalised in October amid the global credit crisis after the economy collapsed under the weight of their debts.
"Iceland is in the midst of a banking crisis of extraordinary proportions," John Lipsky, acting IMF chairman, said in a statement on Wednesday.
"The three main banks, accounting for about 85 per cent of the banking system, collapsed within a time span of less than one week."
$827 million will be made available to Iceland immediately and the remainder of the IMF loan would be paid out in eight installments of $155m, according to the statement.
Lipsy said Iceland faced serious economic challenges but has promising long-term prospects because of its well-educated workforce and abundant natural resources.
"The road ahead is difficult. The programme is subject to exceptionally large uncertainty and significant risks, reflecting the unprecedented magnitude of the banking sector collapse," he said.
The approval of the loan had been held up by a dispute between Iceland and Britain over Britons' savings in failed Icelandic banks. Britain wanted the deposits of its citizens paid back first.
The loan is the first to a Western European country from the IMF since Britain received one in 1976.
Trade in Iceland's currency has all but stopped and the country is braced for a sharp economic contraction in the coming year.
There is also the possibility of further interest rate hikes following the six-point increase to 18 per cent last month, that was reportedly recommended by the IMF.
On Tuesday, Geir Haarde, the Icelandic prime minister, struck an optimistic tone about the country's economic future.
"With help from the International Monetary Fund, we will be able to quickly put this difficult period behind us," Haarde told the German business newspaper Handelsblatt.
"We will be back in 2010."
In total, Iceland expects it could need to borrow some $24bn over several years to ensure its financial system and currency can function properly again.
Other Nordic countries, the European Union and Russia have all been asked for help by the Icelandic government.