Thanks Mikhail, you're right - I had thought if I didn't use these entities, then my page wouldn't validate as correct HTML. But the problem was Dreamweaver sets the following meta tag:
<meta http-equiv="Content-Type" content="text/html; charset=ISO-8859-1" />
so they weren't validating. When I removed this, they validated... However, as I'm using an English keyboard, I do find it quicker to just use the prompted "ð" than try to remember the key codes which generate "ð" for example, or go through the hassle of having to keep changing my keyboad layout to Icelandic. I just think it's a shame that VWD doesn't have intellisense for these entities when they have intellisense for everything else!