The origin of high Curie temperature ferromagnetism in dilute magnetic semiconductors and oxides has often been attributed to clustering and crystallographic phase separation of magnetic atoms, which may have a detrimental impact on the properties of the host material for target applications. We present Density Functional Theory calculations on the stability and magnetic interactions of embedded Fe+1 ions in diamond by considering various possible cluster configurations. We find that Fe ions have a strong tendency to form embedded clusters in diamond, with larger cluster sizes (n>3) suppressing the induced spin moment. Also, we find that the electronic structure of the stable embedded Fe+1 clusters is insulating, in contrast to homogeneous distribution, where a half metallic character with 100% spin polarisation at the Fermi level has previously been predicted. These results present important implications to the understanding of the properties of transition metal dopants in diamond, as well as in other dilute magnetic semiconductors where the effect of aggregation of dopants has generally been neglected.