The hedge funds in turn argue that the government has no legal right to force them to accept a haircut on the value of their holdings.
The dispute centres on £2bn of Tier 2 bonds sold by Anglo, which the hedge funds argue are governed by English law. They claim that for investors to be legally obliged to accept a lower than face value payout, the bank's senior debt – which the government has said it will pay back in full – must already be in default.
While small compared to the total size of the Irish rescue package, the dispute could have disastrous consequences for the bail-out.
If the hedge funds were to press their case, Ireland could be required to put Anglo into insolvency, which could ultimately mean that depositors would have to make use of the country's guarantee scheme to get their money back.
One banker with knowledge of the discussions said the legal opinion his firm had received was that the Irish government was in the wrong.
Robin Creswell, a senior bond specialist at fund manager Payden & Rygel, said investors trying to force the government's hand were playing a risky game.
"They might have a good legal claim, but when you are dealing with a government in the position of the Irish that will go to great lengths to prevent default, you are entering a very complex situation."
The cost of bailing out the Irish banking system has so far cost the state €44bn, and this year the country's budget deficit is projected to equal 32pc of GDP – 10 times the amount permitted under European Union guidelines.
Speaking on Thursday, Irish finance minister Brian Lenihan was clear that while junior debt holders would make a "significant contribution" to the cost of the bank bailouts, depositors and senior debt holders would be protected.
Mr Lenihan attempted to calm market fears over the effect the cost of the bailout would have on the country and said the government would be publishing a four-year budget plan in November on how it intends to cut the deficit.
Ireland is not the only eurozone country coming under pressure from the market, with Moody's yesterday cutting the credit rating of Spain over fears of weak economic growth and the government's ability to reduce the deficit.
