British Prime Minister Theresa May chaired an emergency meeting of ministers and security officials on Monday to discuss how to respond after Iran seized a UK-flagged tanker in the Gulf.
In a dramatic escalation of tensions, Iran's Islamic Revolutionary Guard Corps seized the Stena Impero on Friday in the strategic Strait of Hormuz.
The move came two weeks after British authorities seized an Iranian tanker off Gibraltar on suspicion of breaching sanctions against Syria, and against a backdrop of brinkmanship between Washington and Tehran.
"The ship was seized under false and illegal pretences and the Iranians should release it and its crew immediately," May's spokesman told reporters.
"We do not seek confrontation with Iran but it is unacceptable and highly escalatory to seize a ship going about legitimate business through internationally recognised shipping lanes."
Following criticism over security protection for British-linked ships in the region, the spokesman said the high volume of ships moving through the Strait of Hormuz "makes it impossible to escort vessels individually".
Foreign Secretary Jeremy Hunt is expected to update parliament later Monday.
The EU has condemned Iran's action and Hunt spoke to his French and German counterparts on Sunday.
They agreed that "safe passage for vessels through the Strait of Hormuz is a top priority for European nations, while avoiding any possible escalation in the region", a British statement said.
Tensions in the Gulf have ramped up since May, when the US boosted its military presence in response to what it called indications of a "credible threat" from Iran.
The British government had warned its ships to avoid the Strait of Hormuz, a chokepoint for about a third of the world's sea-borne oil.
But questions are being asked in London about why it was not more proactive in protecting ships after the Gibraltar incident, which provoked fury in Tehran.
The standoff comes at a sensitive time for Britain, with May due to resign on Wednesday over her Brexit strategy, with former foreign minister Boris Johnson the overwhelming favourite to replace her.
Junior defence minister Tobias Ellwood said Sunday that Britain would be looking "at a series of options" on how to respond to Iran's actions.
Iranian authorities said they detained Stena Impero after the tanker failed to respond to distress calls and turned off its transponder after hitting a fishing boat.
But in a letter to the UN Security Council, British charge d'affaires Jonathan Allen accused Tehran of "illegal interference".
He said there was no evidence of a collision and said the vessel had been in Omani waters with its transponder switched on when it was approached.
Iranian authorities have said the fate of the Swedish-owned tanker depends on the cooperation of its crew.
But they insisted the 18 Indians, including the captain, three Russians, a Latvian and a Filipino on board are all in good health and anchored in a safe place.
Iran released video footage showing the tanker being surrounded by speedboats before troops in balaclavas descend a rope from a helicopter onto the vessel.
In an audio recording of a radio exchange obtained by a London-based maritime firm, an Iranian officer can be heard ordering the tanker to change course "immediately".
The British frigate HMS Montrose, which was in the Gulf at the time, intervenes to inform the Stena that its passage must not be impaired under international law.
The Iranians reply: "No challenge is intended... I want to inspect the ship for security reason."
European powers have been drawn into an escalating row between the United States and Iran over the Islamic republic' nuclear drive.
Tehran has been at loggerheads with Washington since May 2018, when President Donald Trump unilaterally withdrew the US from a landmark 2015 deal that put curbs on Iran's nuclear programme in exchange for sanctions relief.
The US administration reimposed tough sanctions on Iran, which retaliated by increasing its enrichment of uranium beyond limits set in the nuclear accord.
Since May, a number of ships have been sabotaged or attacked in the Gulf, while in June, Trump called off air strikes against Iran at the last minute after Tehran downed a US drone.
Friday's incident began hours after a Gibraltar court extended by 30 days the detention of the Iranian tanker, Grace 1, seized on July 4.