The Sensex fell about 1%, heading towards its biggest weekly fall of the year as lenders slumped after data showing consumer inflation edged up, raised concerns about interest-rate cuts and sent bond yields surging.
The falls marked a sharp retreat from earlier gains of nearly 1% on optimism about the government's reform agenda after parliament on Thursday passed a bill raising foreign investment limits in the insurance sector.
But sentiment soured eventually, with investors focusing on data released late on Thursday that showed consumer prices edged up more-than-expected by 5.37% in February, marking a third consecutive month of rise.
The Reserve Bank of India cut interest rates last week for the second time in as many months, and analysts had expected the central bank to next ease monetary policy at its policy review in June.
Analysts warned a more cautious approach on rate cuts could deprive markets of catalysts after indices hit record highs early this month.
"We are left with no triggers now. Investors will be looking for the fourth-quarter earnings next month to take a fresh view. However, any fall will bring down valuations to a comfort zone," said Daljeet S Kohli, head of research at IndiaNivesh.
The benchmark BSE Sensex was down 0.98% at 28,645.85 after gaining as much as 0.9%.
The index was heading for a loss of 2.7% this week, the worst since the week ended Dec. 12, 2014.
The broader Nifty was down 1.01% at 8,687.35, on track for a loss of 2.8% in the week.
Interest rate-sensitive banking stocks fell, with NSE bank index down 1.3%. ICICI Bank fell 1.2% and HDFC Bank lost 1.4%.
Lenders were also hurt as they are big holders of debt, which fell on Friday after the CPI data.
The benchmark 10-year bond yield by 0738 GMT was trading up 5 basis points at 7.77%, after hitting 7.78%, its highest since Jan. 14, earlier in the day.
Recent outperformers also fell. ITC Ltd, which gained 2.5% in the previous session on reports of cigarette price hike, dropped 1.7%.
Shares in DLF Ltd gained 6.4% after a tribunal ruled in favour of the property developer, reducing the tenure of a ban from accessing capital markets imposed by the markets regulator last year.