Muslims must want to drink a lot. Iceland has a lot of drunks.
Just not all that much land to go around in Iceland.
Maybe a little room could be found on top of a thermal vent a few miles out of town. Since these Muslims come from relatively warm countries, they may be happier to have some scalding steam blowing through their mosque.
The Icelanders are a lot closer to the worship of Odin than they are to the worship of Allah. So awarding a permit to the Pagans does make more sense.