'Time for change'
The Independence Party, which had held a parliamentary majority in Iceland for 70 years, took 23.7 per cent of the vote, or 16 seats.
Johanna Sigurdardottir, the prime minister and leader of the Social Democrats, claimed victory on Saturday.
"The nation is settling the score with neo-liberalism, with the Independence Party, who have been in power for much too long," she said.
"The people are calling for a change of ethics. That is why they have voted for us."
While conceding defeat, Bjarni Benediktsson, the Independence Party leader, promised that his party would soon return to power.
"We lost this time but we will win again later," Bjarni Benediktsson said.
The win by the Social Democrat/Left-Green alliance marks the first time that centre-left parties have held such a strong position in Iceland.
The previous government fell in January, when protesters took to the streets after the country's three main banks buckled under huge debts run up in order to fund their overseas expansion into financial services.
The ensuing economic crisis saw the value of Iceland's currency plummet and the government agree to a $10bn rescue package led by the International Monetary Fund (IMF).
The protests pushed the government to resign and the left-wing Social Democrats formed a caretaker government in coalition with the Left-Green party and called the early election.
Unemployment and inflation have spiralled in Iceland, and the IMF has predicted that the economy will shrink by about 10 per cent in 2009.
The Social Democrats and the Left-Greens will now need to bridge their differences over joining the European Union.
The Left-Greens are opposed to joining the bloc, while Sigurdardottir supports joining the EU and adopting the euro.
"EU membership application is a priority issue for the Social Democrats ... it is necessary to achieve stability," she said.
The new government also faces the issues of how to cut budget spending and raise revenues, as well as how to tackle the country's surging unemployment.
About 228,000 people were eligible to cast their ballot in Saturday's elections.