The BSE Sensex tumbled 3 per cent on Thursday in its biggest one-day fall in almost 16 months as the Libyan turmoil sent oil prices to their highest in nearly 2-½ years and threatened global economic growth.
Financials bore the brunt of the investor selloff on worries spiralling energy costs would accelerate stubbornly high inflation and force aggressive monetary tightening by the central bank, which has raised interest rates seven times over 11 months.
Prime Minister Manmohan Singh vowed on Thursday to control inflation, a problem that has sparked street protests this week and added pressure on the government already under fire over corruption scandals.
Automobiles and property developers, two sectors that could be hit by higher borrowing costs, also slid.
"It is a double whammy," said Rakesh Rawal, head of private wealth management at Anand Rathi Financial Services. "The things were not going right for India with the corruption and inflation issues, and the scene in the Middle East is adding to the woes."
The 30-share BSE index dropped 545.92 points to 17,632.41, its lowest close in two weeks. All of its components closed in the red. The one-day percentage fall was the biggest since Nov. 3, 2009.
Trade was volatile as monthly derivatives contracts expired on the National Stock Exchange.
Fears the revolt in Libya could spread to other oil producing countries in the Middle East sent Brent oil surging more than 7.5 percent to its highest since August 2008. At $119.79 a barrel, Brent has risen around 15 percent in four days.
India imports about 80 percent of the oil it consumes and the global price spiral could add to New Delhi's woes of tackling high food inflation.
Duvvuri Subbarao, governor of the Reserve Bank of India, told a university convocation on Thursday the central bank faced a challenge of maintaining price stability without hurting growth or disturbing financial stability.
Data released on Thursday showed food inflation in Asia's third-largest economy accelerated slightly in mid February on rising prices of milk and fruits.
"Let us see what comes up at the budget," said Arun Kejriwal, director of research firm KRIS. "It is a tightrope walk for the finance minister between containing inflation and managing growth."
The government is expected to boost spending on social programmes in a populist budget on Monday, even as India is threatened with a potentially ballooning subsidy bill for food and fuel.
The main index is down 14 percent in year-to-date, with foreign funds withdrawing $1.6 billion.
ICICI Bank and HDFC Bank, which had raised their lending rates by 50 and 45 basis points respectively effective Thursday, fell 5.4 percent and 2.2 percent.
Top lender State Bank of India fell 3.5 percent, and the banking sector index dropped nearly 4 percent.
Leading car maker Maruti Suzuki slid 1.7 percent, while Tata Motors that also makes trucks lost 7.5 percent. Utility vehicle and tractor maker Mahindra & Mahindra skidded 3.7 percent.
The auto index fell 3.5 percent.
Real estate companies DLF and Unitech shed 3.1 percent and 2.8 percent respectively, while the realty index was down 3.5 percent.
Oil explorer Cairn India bucked the trend and closed 1.1 percent higher, helped by firm crude oil prices.
State-run oil marketing companies Bharat Petroleum Corp, Hindustan Petroleum Corp and Indian Oil Corp dropped between 3 percent and 4.3 percent. The firm will have to bear a higher burden as retail fuel prices are set by the government.
More than three shares declined for every share that advanced in the broader market. Volume improved to 330 million shares, compared with 30-day daily average of 288 million shares.
The 50-share NSE index closed 3.2 percent lower at 5,262.70 points.
World equities measured by MSCI All-Country World Index dropped 0.2 percent by 1026 GMT while the more volatile MSCI emerging markets index lost 0.9 percent.