"Recent data and the central bank forecast published today ... confirm that Iceland's economic recovery continues, despite weakening global growth and increased uncertainty," Sedlabanki said in a statement.
The increase was only the second since October 2008, when the rate sky-rocketed from 12 to 18 percent as the country's economy and banking system collapsed after US investment giant Lehman Brothers imploded.
Iceland was particularly hard hit by the financial crisis, with its three major banks becoming insolvent within a matter of weeks and it was forced to seek a $2.25 billion bailout from the International Monetary Fund.
Since then, the North Atlantic island nation has struggled to return to growth but the central bank felt confident enough to raise rates for the first time since the crisis in August, also by a quarter of a point.
Sedlabanki, whose rate hike comes as many developed countries are slashing borrowing costs, said the "ominous global economic outlook has not as yet made a significant impact on the domestic economy.
"Output is expected to grow slightly faster in 2011 and 2012 than was forecast in August, and inflation is projected to be somewhat lower in coming quarters as a result of a stronger krona and lower imported inflation," the bank explained.
Not everyone agreed with the rate decision.
"I'm totally flabbergasted," Gylfi Arnbjornsson, president of the Icelandic Confederation of Labour, said in a statement.
"The world is battling yet another financial crisis and politicians and central banks all over the world are trying to pave the way for the economy to recover, among other things, by keeping interest rates low," he said.
"The central bank's Monetary Policy committee is, by raising interest rates, working against those goals," he added.
Islandsbanki analyst Jon Bjarki Bentsson said the hike was understandable.
"The Icelandic economy is in a somewhat different position than many other European economies," he told AFP, pointing out that "local banks and the government are not facing liquidity problems, domestic inflation is high and the credibility of monetary policy is low."
Iceland's tight capital controls, introduced as the krona crumbled in 2008, had also managed to "isolate the country to a degree from the downturn in foreign markets," he said.
Sedlabanki said the krona had appreciated slightly and the terms of trade were considerably more favourable than forecast in August.
"The domestic economic recovery has continued and financial conditions of households and firms have improved," it noted.
Economic growth in the first half of 2011 was 2.5 percent, and is forecast to be just over 3.0 percent for the year as a whole, slightly higher than the August estimate, the central bank said.
It predicted growth of 2.3 percent next year and average 2.5 percent annually for the next three years.
Inflation remained a top concern and Sedlabanki governor Mar Gudmundsson told a news conference that "we are raising interest rates because of inflation, not the economic recovery."
Icelandic inflation has risen sharply in recent months and in October stood at 5.3 percent, more than double the official target of 2.5 percent and up from 1.8 percent in January.