I think it is a French colony in the Caribbean. Here's why:
Sebastian is Caribbean
He is supposed to be a Jamaican Red Crab
There is a hurricane
French Colony because of the cook, the baguettes, the berets etc,
Also, in WHSmith there is a disney puzzle of the earth, and Ariel and Flounder are jumping out of the Gulf of Mexico
On Yahoo I heard it was set in Croatia. That is my best guess. Sorry. I say that because I really don't know but I suggest you compare the movie with Croatia and Denmark. The scene were Eric is throwing the flute the beach looks like Denmark but the town reminds me of Croatia.
It is definitely not clear, but there are several hints arguing that it's set in Denmark:
1. The Author (H C Andersen) is from Denmark
2. In the movie Ariel sits in the same position and on a similar stone as the statue 'The Little Mermaid' in Denmark.
4. Disney named the fish 'flounder' (a fish to be found in Denmark) even though he is obviously a more exotic fish.
3. Denmark have had several kings/princes through history named Eric.
4. Despise Andersen describing the beach the little mermaid wakes up on, as an exotic beach with palms and lemon trees, Disney portrays it as a typical scandinavian beach with only sand, grass and hills.