The roughly 4,000 residents of Grindavik, a fishing port around 40 kilometres (25 miles) from the capital, were evacuated on November 11 after magma shifting under the Earth's crust caused hundreds of earthquakes -- a warning of a likely volcanic eruption.
Thousands of smaller tremors have since shaken the area along the Reykjanes peninsula, with several homes and other structures suffering severe damage.
"No country is better prepared for natural disasters than Iceland," Prime Minister Katrin Jakobsdottir said at a press conference.
"We have long experience in dealing with volcanic eruptions. We know that it's not necessarily a sound decision to build for example defence mechanisms when you have such a great uncertainty where an eruption can come up," she said.
The Reykjanes peninsula had not experienced an eruption for eight centuries until 2021.
Since then, three eruptions have struck -- all in remote uninhabited areas -- and volcanologists say this could be the start of a new era of activity in the region.
That has raised the prospect that residents may not be able to return to their homes any time soon.
"Our main priority is really to embrace those people, ensure that they have adequate salaries and to find proper housing for them for the next weeks or months," Jakobsdottir said.
"We have proposed a bill for the parliament to ensure the salaries for the next three months. And we are working as fast as we can to ensure proper housing for those people," she said.
Iceland is home to 33 active volcano systems, the highest number in Europe, and towns have been hit before.
The country has been on edge for the past week, waiting for a potential eruption near Grindavik.
