Southgate's side had hoped for a confidence-boosting victory at Wembley before travelling to Germany.
But Jon Dagur Thorsteinsson's first half goal spoiled England's farewell and led to the lacklustre hosts being booed off at half-time and the final whistle.
Against a team ranked 72nd in the world, who were unable to qualify for the Euros, Cole Palmer, Anthony Gordon and Kobbie Mainoo all failed to make compelling cases to be included in the starting line-up at the Euros.
Adding to Southgate's worries, John Stones didn't reappear after the interval, possibly a precautionary move after the England centre-back fell awkwardly in the first half.
Southgate said his starting line-up was "close" to the team that will face Serbia in England's Group C opener in Gelsenkirchen on June 16.
If that is the case, he will need to coax a substantially improved effort from a group that looked short on energy and composure in the absence of resting Real Madrid star Jude Bellingham.
Bored fans spent most of the night entertaining themselves by buzzing the pitch with paper aeroplanes and few stayed for the post-match lap of honour.
While Southgate can point out that this result will count for nothing when England start their bid to win a first major trophy in 58 years, it was still an alarming performance that raised questions about key areas of his team.
Southgate showed a rarely seen ruthless edge on Thursday when he axed Manchester City winger Jack Grealish and Tottenham playmaker James Maddison from his 26-man squad due to their poor recent form.
The England boss also displayed no sentiment by leaving out Manchester United defender Harry Maguire, who has been a mainstay of his reign but was unable to recover from a calf injury.
Sloppy England
Whether those decisions prove wise will be determined over the next month in Germany, but the absence of Maguire could be especially damaging.
Marc Guehi replaced Maguire alongside Stones in England's central defence, but the pair delivered a shaky effort, with Ezri Konsa faring little better after his second half introduction.
Iceland famously inflicted one of England's most humiliating defeats when they beat Roy Hodgson's team in the last 16 at Euro 2016.
Iceland captain Johann Gudmundsson was in the line-up that evening in Nice and he must have had flashbacks when Thorsteinsson gave his side a surprise lead in the 12th minute.
Running at Stones with intent, Thorsteinsson cut inside before unleashing a low strike from the edge of the area that beat Ramsdale at his near post.
England's defending was sloppy while Ramsdale might feel he could have done better, his slow reaction extending a dismal season for the 26-year-old after losing his place at Arsenal.
With just two clean-sheets in their last seven games, England's defensive frailties will be concerning for Southgate.
Harry Kane wasted a golden opportunity to equalise when he met Cole Palmer's cross with a close-range volley that failed to hit the target.
Southgate's men lacked energy and rhythm, mustering just one shot on target in the opening 45 minutes.
Palmer let the visitors off the hook when he tried to go around Iceland keeper Hakon Rafn Valdimarsson instead of shooting.
Southgate sent on Bukayo Saka, Trent Alexander-Arnold, Joe Gomez and Ivan Toney, who immediately blazed over from a good position.
That was a fitting coda to England's disappointing evening, one that Southgate will hope is long forgotten by the time his team are finished in Germany.
