Sensex declined 0.8 per cent on Wednesday, hurt by weak world markets as concerns the US economic recovery is slowing deterred investors, with anxiety about a Europe-wide bank stress test further dampening sentiment.
Energy giant Reliance Industries and financials contributed the most to the main index's losses.
The 30-share BSE index shed 0.81 per cent or 143.45 points to close at 17,471.03 points, with 27 of its components closing in the red.
The US service sector showed economic growth in June, but at its slowest pace since February, heightening concerns about sluggish economic recovery in the world's largest economy.
Investment flows into the world's four biggest emerging economies -- Brazil, Russia, India and China - slowed slightly in the first half of 2010, but growth rates and the pace of dealmaking remain strong, data shows.
Foreign funds have pumped in around $6.8 billion in Indian equities so far in 2010, with a portion of it parked in the primary market. The index is barely changed so far this year.
The funds had pumped in a record $17.5 billion in 2009, which helped the benchmark index gain 81 per cent.
Market participants expect Indian equities to move up on better corporate earnings propped up by robust economic growth.
"We still argue for greater upside than downside for the market," Morgan Stanley said in an India Strategy note.
Morgan Stanley said its bear case calls for 18 per cent downside to the BSE Sensex over the next six months.
"The base case is that we are heading higher and we rate the probability of our bull case higher than our bear case."
Corporate taxes during April-June rose 21.65 per cent on the year to 434.4 billion rupees, the finance ministry said in a statement on Tuesday.
"The fundamentals of the economy are encouraging. The tax collection figures and direction of budget deficit are positive developments," said Rakesh Rawal, head of private wealth management at Anand Rathi.
"Undoubtedly, the scope of growth in India can attract much more fund flow."
Rawal said that though in the near term the market may stay subdued to the uncertainties regarding global developments, the long-term outlook was definitely optimistic.
The June-September annual monsoon, vital for India's trillion-dollar economy, has picked up after a subdued spell and has covered the entire country, brightening the prospects for farm output and rural incomes.
Billionaire Mukesh Ambani-led Reliance Industries, which has the highest weight on the Sensex, declined 1.8 per cent to 1,052.95 rupees.
Financials were pulled down by broader weakness and on expectations of another round of rate hike this month after last week's surprise move.
India's central bank is expected to hike rates again in its quarterly review on July 27 after a surprise increase last Friday to contain inflation worries, a Reuters poll showed on Monday.
Top lender State Bank of India shed 0.4 per cent while leading private sector rivals ICICI Bank and HDFC Bank dropped 1.5 per cent and 1.2 per cent respectively.
Mortgage lender Housing Development Finance Corp closed 1.3 per cent lower.
Tata Steel, the world's eighth-largest steelmaker, shed 1 per cent after it said on Tuesday sales from its Indian operations stood at 1.4 million tonnes in April-June, almost flat compared with the same period last year.
Declining shares outnumbered advancing ones in the broader market in the ratio of 1.2:1, amid a relatively lower volume of 382 million shares.
The 50-share NSE index dropped 0.9 per cent to 5,241.10 points.
MSCI's all-country world stock index was down 0.7 per cent by 1016 GMT, while the emerging market index dropped nearly 1 per cent.
Leading telecom companies Bharti Airtel and Reliance Communications rose 1.9 per cent and 1.6 per cent respectively.
A government statement said the telecoms ministry has set up a panel to look into mobile firms' concerns over the sector regulator's proposals, including levying a one-time fee on 2G radio spectrum.
* Retailers Pantaloon Retail, Shoppers Stop, Trent and Vishal Retail jumped between 3.5 per cent and 11.5 per cent after India on Tuesday took a tentative step towards opening up the organised retail sector to foreign companies.
* Non-ferrous metals producer Sterlite Industries dropped 2.1 per cent to 159.35 rupees as London copper prices fell more than 1 per cent on weak demand outlook.
Power Grid Corp of India climbed 0.5 per cent to 102.60 rupees after its board approved an investment of 20.34 billion rupees in three projects.
FACTORS TO WATCH
* For technical analysis double click on www.reutersindia.net
* Indian rupee report
*Indian bond report
* Euro slips from 7-week high, stress tests eyed
* Oil falls below $72 on economic worry
* Economic slowdown worries hit stocks
* US stock futures signal dip along with world stocks
* For closing rates of Indian ADRs