A group of small shareholders in nationalised bank Northern Rock has written to the government denouncing the terms set to determine compensation levels, the first step in a legal fight to recover their losses.

The Shareholders' Association - which says it has the backing of around 7,000 shareholders representing 10 percent of the mortgage bank's shares - said on Wednesday it had written a letter asking the government to throw out the current terms.

It has given the government 21 days to respond, after which it will seek a judicial review of the compensation process.

The Treasury has said it should not be required to compensate investors for "value which is dependent on taxpayers support", after the bank borrowed 25 billion pounds from the Bank of England and had access to billions more in guarantees.

But shareholders said that assuming the bank was not a going concern would mean any decision reached by an independent audit would be unfair - and any likely settlement derisory.

"The government is self-serving and has rigged the valuation process," said David Greene, a partner at law firm Edwin Coe and legal representative of the UK Shareholders' Association.

"They are looking to reduce the valuation as low as possible, if not to zero," he told reporters.

Big and small investors in the fifth largest mortgage lender have reacted angrily to its nationalisation which looks set to leave them with little or nothing, and a legal battle has long seemed inevitable. Few, though, expect either hedge funds or retail shareholders to win out.

The small shareholders said on Wednesday that hedge fund SRM, Northern Rock's top shareholder, had also written to the government to start its own legal proceedings. SRM has in the past said it would consider legal action if it does not get book value - a minimum of 400p - for its shares.

The hedge fund was not immediately available for comment.

Under terms published last month by the Treasury for compensation, investors may object to the decision of the independent auditor and, if they refuse a revised view, can appeal to a tribunal.

Northern Rock was brought under public ownership in February after a five-month search for a private sector buyer for the stricken lender which had fallen foul of the global credit crunch. It was the first major nationalisation in decades.