Boyd Tonkin: It's not so quiet - how the tiny giant Iceland manages to make itself heard

It felt like a very Reykjavik moment. In the city hall that perches over the waters of the Tjörnin pond Jón Gnarr, the Icelandic capital's wackily alternative mayor, had just closed his welcome for guests at the Reykjavik literary festival - and the concurrent international PEN congress - with a stirring call to "Free Pussy Riot! Free Liu Xiaobo!" (the jailed Chinese dissident).

Gnarr, by the way, is a genuine comedian (not the amateur political variety) who on his Facebook page solicits verdicts on his tenure with a nod to The Clash: "Should I stay or should I go?" I caught a flash of blue dress at the corner of my eye and turned round to find, yes, the planet's starriest Icelander: Björk Gudmundsdóttir.

In a country of just 320,000 people (but which managed to publish 842 new books last year) everything – and indeed everyone – comes together at some point. Take Björk herself. Novelist and poet Sjón – who heads Reykjavik's Unesco "City of Literature" project – first met her when she was 16, and he 19. "Punk happened to my generation," he recalls when we talk in Alvar Aalto's elegant Nordic House. "I never saw any difference between what my friends in the New Wave bands were doing and what we [the young writers] did".

As for Björk, the future Sugarcube "became an official eighth member of our little Surrealist group". Later, "when the moment came that she wanted a song with an epic and romantic feel, she called me". The result was "Isobel" on her breakthrough album Post. Sjón still "almost exclusively" writes lyrics for his old friend (most recently, three tracks on Biophilia). "It's a great privilege to have her travelling the world and bringing my work to a global audience."

Icelandic words do travel far. From the 13th century, the epic feuds and loves of the Sagas took root in the wider world's imagination. Sjón says that he became "addicted to folk stories" aged eight, and still feels – in visionary historical novels such as The Blue Fox and From the Mouth of the Whale – "constantly engaged in a dialogue with older texts".

In a ruggedly lovely island of empty spaces and harsh lives, the storyteller's words never lost their near-occult force. As writer Jón Kalman Stefánsson explained to me, "To be an Icelander is to talk. The language is what makes us Icelanders." His own fiction has channelled the moods of an exposed place and people for whom "nature and weather is everything" into a trilogy of viscerally poetic novels inspired by the fisherfolk of the West Fjords (Heaven and Hell and The Sorrow of Angels have appeared in English).

How refreshing to visit a nation that bothers to nurture its indigenous writers. Iceland (like Norway) even boasts a stipend system to support authors with individual works. It's not a grant, Sjón insists, but an investment: "It really gave me the opportunity to develop as an author." Of course, Iceland also yielded to the temptations of reckless globalisation. Its madly greedy banks collapsed after 2008 and brought the entire country to its knees. Then the value of culture soon reasserted itself. "Immediately after the crash," reports Sjón, "the number of books borrowed from libraries skyrocketed. Book sales rose." The meltdown confirmed "that we were no good at business". But the living word thrived.

From JRR Tolkien (who mined the language and the sagas) to WH Auden and Simon Armitage, this half-alien edge of the world has enchanted the British literary mind. The tale I took home from Reykjavik – where, from Douglas Coupland to James Fenton and Kiran Desai, a worldwide span of voices also spoke –concerned the value of small-country thinking. You must never close the borders of imagination. Sjón affirms that modern Icelandic culture always draws inspiration from outside and that the work of the 1955 Nobel laureate Halldór Laxness "would have been unthinkable without Surrealism". But still you cherish what you, uniquely and distinctively, possess. More populous states too might profit from that outlook. Instead, our literary chieftains just lick the American boot.

US agents take over the Booker. Time for mutiny

Like Antonia Fraser, I agreed to join the new "e-council" that will advise the judges of the biennial Man Booker International Prize on suitable future candidates. Lady Antonia has now quit on the grounds that we were asked to help without being told of the imminent rule-change that would open up the annual Man Booker to US writers and so alter the entire ecology of both awards. Her annoyance is justified; I too feel deceived. But I'm going to stick around to plague the US agents who appear to run the Booker. It should be fun.

Honour for a shattered memorial

Biennial and open to all forms, the Warwick Prize for Writing (worth £25,000) goes its own sweet way. This week its singular path led to poet Alice Oswald and Memorial: her shattered - and shattering - mash-up of fragments from Homer's Iliad into an eerily monumental elegy for the easily-forgotten dead that all wars deposit like autumn leaves: "Thousands of names thousands of leaves/ When you remember them remember this/ Dead bodies are their lineage/ Which matter no more than leaves" (her version of a famous simile from Book VI of the Iliad).

Oswald's "oral ceremony" of mourning and remembrance has more to say about our mood of dread and doubt about military sacrifice - a mood that a few weeks ago swayed Parliament on Syria, and so for good or ill changed history – than a shelf of routine chronicles of the First World War. If you haven't, read it.