The Icelandic Met Office has warned that a small eruption under an ice cap has begun at Bardarbunga.
The air space over the site has been closed, but all Icelandic airports currently remain open, authorities say.
Iceland’s Eyjafjallajokull volcano erupted in 2010, producing an ash cloud that severely disrupted air travel.
The red alert is the highest warning on the country’s five-point scale.
The Icelandic Met Office said a team of scientists was flying across the region on Saturday afternoon to monitor seismic activity.
“The eruption is considered a minor event at this point,” police said in a statement.
“Because of pressure from the glacier cap, it is uncertain whether the eruption will stay sub-glacial or not.”
British Airways announced it was keeping the situation “under close observation”, but that all its flights were continuing to operate normally for now.
The UK Civil Aviation Authority (CAA) said there would be no impact on flights unless there was an actual eruption.
Bardarbunga is part of a large volcano system hidden beneath the 500-metre (0.31-mile) thick Vatnajokull glacier in central Iceland.
Authorities have previously warned that any eruption in the volcano could result in flooding north of the glacier.
On Wednesday, authorities evacuated several hundred people from the area over fears of an eruption.
The region, located more than 300km (190 miles) from the capital Reykjavik, has no permanent residents but sits within a national park popular with tourists.
The move came after geologists reported that about 300 earthquakes had been detected in the area since midnight on Tuesday.
The Eyjafjallajokull eruption in April 2010 caused the largest closure of European airspace since World War Two, with losses estimated at between 1.5bn and 2.5bn euros (£1.3-2.2bn).
Criticism following the strictly enforced shutdown resulted in the CAA relaxing its rules to allow planes to fly in areas with a low density of volcanic ash.
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