The sanction comes as both the Sri Lankan government and Tamil Tiger rebels ignore repeated pleas from the international community to halt a new chapter of a two-decade civil war that has killed around 68,000 people since 1983.
Britain agreed in 2005 to provide Sri Lanka 41 million pounds ($81.6 million) in debt relief until 2015, in yearly instalments of 3-6 million pounds, as long as it met a series conditions.
Britain was due to make a payment of 3 million pounds this year, or around $6 million, and has paid just half.
"What we have said for this year is we are making half of the agreed payment because there is an ongoing consultation process about progress towards meeting the conditions agreed between the two governments," the spokesman for Britain's mission in Colombo said.
"The remainder of the money will be paid to Sri Lanka when we are satisfied that those conditions have been met."
Truce monitors and rights groups have accused both government forces and the Tigers of repeated violations of a now tattered 2002 ceasefire pact, amid a series of human rights abuses and killings blamed on both sides.
The Tigers are fighting for an independent state in Sri Lanka's north and east, which President Mahinda Rajapaksa flatly rejects, and analysts fear a conflict that has killed more than 4,000 people in the past year alone will rumble on for years.
- Reuters - Thomson Reuters Foundation
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