The eruption occurred near Fagradalsfjall, a mountain on the Reykjanes Peninsula, located around 30 km (19 miles) south-west of the capital.
Helicopter footage from the Icelandic Meteorological Office (IMO) showed magma spewing into the night air and lava flows streaming from the eruption site.
More than 40,000 earthquakes have occurred on the peninsula in the past four weeks, a huge jump from the 1,000-3,000 earthquakes registered each year since 2014.
The eruption posed no immediate danger to people in Grindavik or to critical infrastructure, IMO said.
Unlike the eruption in 2010 of the Eyjafjallajökull volcano, which halted approximately 900,000 flights and forced hundreds of Icelanders from their homes, this eruption is not expected to spew much ash or smoke into the atmosphere, IMO said.
Reykjavik's international Keflavik airport was not closed following the eruption, but each airline had to decide for themselves if they want to fly or not, IMO said.