A volcano spouting lava in the south of Iceland has showed signs of increased activity, leading scientists to warn it could trigger a far more powerful eruption at a nearby geological hotspot.

The eruption near the Eyjafjallajokull glacier, which began shortly before midnight on Saturday, sent steam 4 kilometres up in the air.

"Eyjafjallajokull hardly makes a move without Mount Katla wanting to get in on the action," said Pall Einarsson, a geophysicist at the University of Iceland. "It is therefore of utmost importance to watch events carefully."

An eruption at Mount Katla could melt huge amounts of ice and cause massive floods, potentially affecting a town of 300 people nearby, Einarsson added. Three previous eruptions at Eyjafjallajokull have triggered eruptions at Mount Katla.

On Sunday, rescue teams evacuated 500 people from the rural area around the volcano and police declared a local state of emergency. International flights were diverted because of the risk of interference from ash clouds.

Iceland sits on a volcanic hotspot in the Mid-Atlantic Ridge and has relatively frequent eruptions, though most occur in sparsely populated areas and pose little danger to people or property. The last eruption in Iceland took place in 2004.