The arctic forest-tundra ecotone (FTE) represents a major transition zone between contrasting ecosystems, which can be strongly affected by climatic and biotic factors. Expected northward expansion and encroachment on arctic tundra in response to climate warming may be counteracted by natural and anthropogenic processes such as defoliating insect outbreaks and grazing/browsing regimes. Such natural and anthropogenic changes in land cover can substantially affect FTE dynamics, alter ground albedo (index of the amount of solar energy reflected back into the atmosphere) and provide important feedbacks into the climate system. We took advantage of a naturally occurring contrast between reindeer grazing regimes in a border region between northern Finland and Norway which was recently defoliated by an outbreak of the geometrid moth. We examined ecosystem-wide contrasts between potentially year-round (but mainly summer) grazed (YRG) regions in Finland and mainly winter grazed (WG) regions in Norway. We also used a remotely sensed vegetation index and albedo to quantify effects on local energy balance and potential climate feedbacks. Although differences in soil characteristics and ground vegetation cover were small, we found dramatic differences in the tree layer component of the ecosystem. Regeneration of mountain birch stands appears to have been severely hampered in the YRG regime, by limiting regeneration from basal shoots and reestablishment of individual trees from saplings. This has led to a more open forest structure and a significant 5% increase in spring albedo in the summer grazed compared to the winter grazed regions. This supports recent suggestions that ecosystem processes in the Arctic can significantly influence the climate system, and that such processes must be taken into account when developing climate change scenarios and adaptation strategies.