Almost every store in Reykjavik that I walked by was selling some item (hat, mittens, scarf, sweater) hand-knitted using Icelandic yarn. But the best part was definitely seeing all these beautiful traditional Icelandic sweaters with yoke colorwork -- I'll show you the hand-knitted sweaters that I bought in another post.
Varma is a popular clothing brand that sells hand-knitted lace scarves and hand-knitted fair-isle accessories.
Window display of Storkurinn
Unfortunately, most of the yarn stores were closed during our visit because of the end-of-year holidays but I was able to peek at Storkurinn (which sells yarn as well as fabric) and Erla. Both stores are easy to find on Laugavegur (one of the main shopping streets) or off of it.