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The chancellor has confirmed the government is to provide a £200 billion liquidity fund for UK banks and a further £50 billion investment into invididual banks themselves.

The £50 billion investment is expected to be used to shore up LLoyds TSB, Barclays and Royal Bank of Scotland (RBS).

Banking stocks began to recover on the news with shares in HBOS up 27 per cent and shares in Royal Bank of Scotland recovering 12 per cent by 08:24BST.

However, the FTSE 100 index as a whole plunged and was down 3.68 per cent by 08:32 BST.

Speaking to GMTV Alistair Darling said he was also prepared to stand behind those savers that were fearing they had lost everything as a result of the collapse of Iceland's second largest bank yesterday, Landsbanki, which operated the internet bank Icesave.

Mr Darling said the government would be "pursuing the Iceland government which has defaulted on its obligations but I intend to stand behind those who saved with Icesave and I will say more about that in the House of Commons later today."

Of the bank rescue package the chancellor said: "We do need to build up the banking system because after all our economy relies on it."

Meanwhile Mr Darling outlined three courses of action the government would be taking to shore up the banking system.

The government is making £200 billion available to provde liquidity to the money markets - effectively pumping cash into the money markets to restore confidence and try to encourage the banks to begin to lend to one another again.

The government is providing £25 billion immediately which it is investing in the eight biggest banks in the UK for which it will receive preferred shares, meaning that any dividend to be paid out will be paid to the government first. A furter £25 billion is available from the government if it is needed.

And finally the government is to guarantee all loans that banks make to each other - again in order to restore confidence in the banking system - up to around £250 billion for which it will charge a fee to the banks for providing the guarantee.

Yesterday Mr Darling joined the governor of the bank of England and the head of the Financial Services Authority in holding talks with the prime minister at No 10.

The chancellor provided few concrete details of the plan when he spoke to journalists after leaving the talks with Gordon Brown, Mervyn King and Lord Turner. But the talks went on throughout the night and are only thought to have broken up at 05:00 BST.

It is being reported that as part of the deal, the government has also demanded a boardroom shake-up at RBS, one of the most troubled banks. Sir Fred Goodwin, the bank's chief executive, and Sir Tom McKillop, the chairman are expected to leave. However, the chancellor refused to comment on suggestions he and the prime minister had demanded such action when questioned on Sky News this morning, saying that it was up to the individual banks to make decisions of this kind and if they had an announcement to make they would make that announcement themselves.

Meanwhile the prime minister in a statement earlier said that "extraordinary times call for bold and far reaching solutions".

"This is not a time for conventional thinking or outdated dogma but for fresh and innovative intervention that gets to the heart of the problem.

"These decisions on stability and restructuring are the necessary building blocks to allow banks to return to their basic function of providing cash and investment for families and businesses."

The Downing Street talks were held in reaction to a second day of panic on the FTSE 100, particularly on banking stocks.

Royal Bank of Scotland lost 39 per cent of its value in another turbulent day, while Barclays and Lloyds TSB fell nine per cent and 13 per cent respectively.

This followed Monday's unprecedented falls on the FTSE 100, which slumped to its worst daily decline for more than two decades.

The Nikkei 225 also fell nine per cent last night - its biggest one day fall since 1987 - as a result of fears of a banking collapse.