As delegates at the annual World Islamic Banking Conference gathered in Bahrain, something of a pall fell over the conference centre in Manama.

This showpiece event, packed with bankers from the Gulf, the Levant, the Maghreb, Pakistan and India, South East Asia and the City of London, has always been a bit of a back-slapping, self-congratulatory affair. Every year key speakers triumph the great strides that Islamic finance has taken in the past 12 months and extol the virtues of faith-based banking.

Up until recently the growth of the sector was phenomenal. The sector is worth about $800 billion globally and has grown at an annual rate of 10%-15%. Islamic finance has not just blossomed in its heartland, the Arabian Peninsula, but down in South East Asia.

Islamic banks such as CIMB were more than giving the conventional banks a run for their money on the retail banking and investment banking fronts. New firms were springing up all over the world in those halcyon days before Lehman's fall from grace.

The City of London was being quietly Islamized with the arrival of Muslim money in the guise of Savile Row-suited veterans like David Testa, who set up Kuwaiti-backed Gatehouse Bank in 2008. This was the fifth Islamic banking licence granted in the UK and it seemed the persuasive call of the muezzin had made its way to the top table in finance and government in Britain.

The Brown and Balls double-act at the Treasury championed the cause of Islamic finance, promising that Britain would be the first major Western nation to issue a sovereign Sukuk, or Islamic Bond. Then, Gordon Brown moved next door to No.10 and Ed Balls moved to Schools, and the enthusiasm for Islamic finance at the Treasury waned.

But this was the exception as opposed to the rule, and the world's bankers "filled their boots" with corporate and sovereign Sukuk - such as Dubai's now notorious $3.52 billion Nakheel Islamic bond, the world's biggest Sukuk.

The enthusiasm that bankers and investors had for Sukuk, most notably from the start of the credit crunch, was down to the fact that Islamic finance had been marketed as a low-risk endeavour. The industry argued that it was savvier than its competitors on Wall Street and in the City, as Islamic economics was an ancient system that was highly risk-averse, transparent and ethical. Last year at the WIBC conference, Rasheed Mohammed al Maraj, Governor of the Central Bank of Bahrain, was declaring to a rapturous audience - with just a hint of Schadenfreude - that Islamic finance was immune from the credit crunch, although he did add the caveat: "This does not mean that Islamic finance is risk free. We still have some concern about the concentration of risk. There is a lot of [industry] focus on real estate."

Fast forward a year on and Islamic bankers are as popular as the rest of the banking profession. The global financial industry has been in the intensive care ward throughout 2009 as it was slowly being nursed back to health. Then two weeks ago, the patient suffered another shock - the threat of default by Dubai's Nakheel, as parent company Dubai World asked for a six-month standstill on repayments which were due today.

Hence, the sackcloth and ashes among Islamic financial leaders meeting in Bahrain last week. There has been a spirit of unity and the speakers put on a brave face. But the whole future of Islamic finance is under question as Sukuk are so central to the development and spread of the industry. If the Nakheel Sukuk is found wanting, the whole concept of Sukuk is thrown under the spotlight.

Questions first started to be asked about the underlying principles of the industry over a year ago, when the $165m East Cameron Gas Sukuk in the US defaulted. When investors tried to recoup some of their losses, legal problems arose over the rights of the bondholders; these were eventually patched together, but were the precursor to the Nakheel situation. The Dubai Sukuk in question was listed on Nasdaq Dubai, but it is governed by English law in English courts. However, even if Nakheel's creditors were to win in an English court, the judgment would be re-examined in Dubai. Even if the English ruling were upheld, the creditors could not necessarily seize anything that counted as government property, which includes most of Dubai World, the holding company's domestic assets.

Thus creditors face the worst of both worlds, namely their claim has no sovereign guarantee, explicit or implicit, and any assets they might seize probably enjoy sovereign immunity, unless the government chooses to forgo it.

The relative immaturity of Islamic finance has been its Achilles Heel. It has grown so fast in myriad ways that the regulatory infrastructure has not caught up. Its soft underbelly was, due to the exclusion of large areas of the investment universe, an over-exposure to property, and nowhere was this more acute than in the glittering developments of an octane-fuelled Dubai.

But the Arab World is not bubble-proof. Although casual visitors have been impressed by the rise of Dubai and some of its neighbours as financial centres and holiday destinations, these countries are still politically, economically and socially immature.

Corporate governance, regulatory enforcement and standards are still vague concepts in a region where ruling families oversee personal fiefdoms.

Islamic finance will survive, but the industry must takes a good look at itself. It needs a common set of standards, best practice and cross-border regulation. It also needs to plough its own furrow - not just replicate conventional Western financial services, with a "Shariah-compliant" product wraparound.

John Foster is the former editor of Islamic Business & Finance magazine and is a leading expert on Middle Eastern affairs