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The molecular epidemiology of HIV-1 in Iceland has not been described so far. Detailed analyses of the dynamics of HIV-1 can give insights for prevention of virus spread. The objective of the current study was to characterize the genetic diversity and transmission dynamics of HIV-1 in Iceland. Partial HIV-1 pol (1020 bp) sequences were generated from 230 Icelandic samples, representing 77% of all HIV-1 infected individuals reported in the country 1985–2012. Maximum likelihood phylogenies were reconstructed for subtype/CRF assignment and determination of transmission clusters. Timing and demographic growth patterns were determined in BEAST. HIV-1 infection in Iceland was dominated by subtype B (63%, n = 145) followed by subtype C (10%, n = 23), CRF01_AE (10%, n = 22), sub-subtype A1 (7%, n = 15) and CRF02_AG (7%, n = 15). Trend analysis showed an increase in non-B subtypes/CRFs in Iceland over the study period (p = 0.003). The highest proportion of phylogenetic clustering was found among injection drug users (IDUs; 89%), followed by heterosexuals (70%) and men who have sex with men (35%). The time to the most recent common ancestor of the oldest subtype B cluster dated back to 1978 (median estimate, 95% highest posterior density interval: 1974–1981) suggesting an early introduction of HIV-1 into Iceland. A previously reported increase in HIV-1 incidence among IDUs 2009–2011 was revealed to be due to two separate outbreaks. Our study showed that a variety of HIV-1 subtypes and CRFs were prevalent in Iceland 1985–2012, with subtype B being the dominant form both in terms of prevalence and domestic spread. The rapid increase of HIV-1 infections among IDUs following a major economic crisis in Iceland raises questions about casual associations between economic factors, drug use and public health.