The 42-year-old, who won the last of his 53 England caps in 2010, is set to take up a player-coach role alongside his former Portsmouth team-mate and IBV boss Hermann Hreidarsson.
James left League One side Bournemouth by mutual consent last month.
One of James' first matches for IBV will be against Portsmouth in a charity match to help raise funds for the cash-strapped club at Fratton Park on 16 April.
Writing on Twitter, James said: "I am going to sign for #ibv in Iceland today. My role is as player/coach, alongside Herman. We are both very excited about the journey ahead."
"I am also looking forward to playing for #ibv in the match at Fratton Park,
16th April. Lets hope the club is sorted, sharpish! #pup."
IBV, who are based in the Vestmannaeyjar islands, which have a population of just over 4,000, finished third in the Iceland domestic league last season.