The win by the Social Democrat/Left-Green alliance marks the first time 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, then head by the Independence Party, agreed 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 - that would be Iceland's biggest slump since it won full independence from Denmark in 1944.
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," she said on Friday. "It is necessary to achieve stability."
Like many other voters, Einar Sigurdsson, an internet entrepreneur, told Al Jazeera that he would be voting for the Social Democrats.
"The Social Democrats have the strategy that I like the most - they will go to the European Union. I think by doing that we will send a signal to the world that we will play with the international community," he said.
"We will also then going to be able to change our currency, and our currency is what has been killing us - it is like gambling today with the Icelandic krona, instead of doing business."
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.