Things got off to a rough start for the Scots when Angus Gunn was forced off with an injury after just seven minutes.
It marked a debut for 22-year-old Ipswich goalkeeper Cieran Slicker, who struggled between the sticks for Scotland.
Iceland broke the deadlock within 60 seconds of the change through Andri Gudjohnsen, who capitalised on an error at the back.
Defender John Souttar responded for Scotland, but his goal was ultimately unable to inspire Steve Clarke's side.
Moments before the half-time break, Lewis Ferguson turned the ball into his own net to restore Iceland's lead.
Scotland looked to have improved in the second period, but a 52nd-minute header by Victor Palsson put the match beyond the hosts.
A VAR check gave the Scots a bit of false hope in the wake of going two down, but the goal stood.
The tech would rear its head again to deny a George Hirst strike, with Scott McTominay ruled to have been in an offside position in the build-up.
The Scottish players have themselves to blame after failing to take their own chances, and the home crowd weren't shy about letting them know that on the full-time whistle.
