Scot Gemmill's first match in charge of Scotland U21s ended in a 2-0 defeat as Iceland went top of Group 3 with one round of fixtures remaining.
Aron Thrandarson opened the scoring on 47 minutes as swirling winds and heavy rain hampered play.
Oliver McBurnie then had a penalty well saved by Runar Runarsson after the home goalkeeper had fouled the striker.
Elias Omarsson doubled the Icelanders lead as they moved above France and Macedonia in the qualifying table.
Scotland hopes of reaching next year's European Championship finals were extinguished after a heavy defeat in Ukraine last month.
That prompted the early exit of coach Ricky Sbragia, with Gemmill stepping up from his role with the under-19s and under-17s.
Looking ahead to the next mission, Gemmill introduced several players from the Under-19s but they could not resist a motivated home side that has lost just once in qualifying.
With two victories from nine matches, Scotland end a hugely disappointing campaign in Macedonia next week.
Iceland lead Macedonia on goal difference, with France one point behind.