I imagine it would be latter, but I am not sure, hence my question. I have little knowledge about Iceland. I know for example in Quebec outside of Montreal, everyone assumes you speak French, regardless of your ethnicity.
I think most Icelanders, including myself, would start off conversing in English as a matter of courtesy; it would be rude to assume that a person of an ethnic minority isn't Icelandic based on their looks. A lot of times they are indeed Icelanders of ethnic minorities, and you avoid a situation embarrassing for both parties, and perhaps make them feel more welcome in the country they were born in.
When I went to Iceland, I was expecting to see close to zero immigrants and their descendants among the Icelandic population. I was surprised to see quite a few people of African and Asian descent working in Icelandic stores and speaking fluent Icelandic with the customers.
I found that the children in Iceland know English surprisingly well. My children were playing with an 8-year-old Icelandic girl who spoke nearly flawless English. I was impressed.