Shares fell 4.13% on Thursday, the sharpest single-day drop in two years, mirroring global markets after the Federal Reserve gave a grim outlook for the US economy.
The benchmark 30-share Sensex index closed down 704.0 points at 16,361.15 at the Bombay Stock Exchange, its second straight day of losses.
Investors sold heavily after European markets opened sharply down and the sentiment remained downbeat with US futures trends indicating a further fall later Thursday.
The Indian currency also fell to a new two-year-low of 49.01 rupees to the the dollar -- a level last seen in September 2009 -- as demand for the safe-haven greenback rose.
The fall in the rupee will fuel India's inflationary woes, making imported goods such as foreign crude oil, on which the country is reliant, more costly.
India's annual inflation is currently near double digits, the highest amongst most leading global economies.
"Given the negative global cues emerging from the US and Asian market, the Indian markets lost ground, with selling pressure seen across most sectors," said Sanjeev Zarbade, vice president with Kotak Securities.
"Global concerns and a weak rupee are reducing risk-appetite," said Hemen Kapadia, chief executive with investment advisory firm Chart Pundit.
The Reserve Bank of India raised rates for the 12th time in 18 months last week to combat inflation, despite signs of slowing growth.
India's top property firm DLF slumped 7.16% to 197.85 rupees while energy giant Reliance Industries fell 6.16% to 786.45.
India's leading vehicle maker Tata Motors fell 5.98% to 154.85 on media reports that the firm has decided to cut production of most of its models in September, including the small-car Nano, due to sluggish demand.