Growing concerns about slowing growth in China and a mixed bag of corporate earnings also hit investor sentiment, pulling down rupee below 63-level against US dollar.
A slump in emerging-market currencies, spurred concerns a sell-off in global equity markets may continue, brokers said.
Overall, 643 shares gained while 1,952 stocks declined on the BSE -- meaning seven out of every ten stocks ended lower.
All 12 BSE sectoral indices ended in the red. Rate-sensitive realty, banking, metal and auto were among the hardest hit.
After dropping 240 points in the previous session, the BSE benchmark BSE Sensex plunged by 426.11 points, or 2.02 per cent to end at 20,707.45, its biggest single-day fall since September 3, 2013 when it sank by over 651 points.
Over 100 stocks on the BSE hit their 52-week lows.
Seeking to assuage investors worried over declining value of the rupee and falling stock markets, the Finance Ministry today said India's economic fundamentals are "very strong" and there is no cause for concern.
The 50-share National Stock Exchange index NSE Nifty dropped by 130.90 points, or 2.09 per cent, to end at 6,135.85, after touching an intra-day low of 6,130.25.
"Weak international cues and rising Indian rupee against US dollar rates are among some key factors that are triggering selling pressure in Indian markets. Uncertainty is also created by upcoming events such as RBI policy meeting and FOMC meeting," said Milan Bavishi-Head Research, Inventure Growth and Securities.
Sectorally, the BSE Banking sector index dropped by 3.97 per cent. However, the biggest loser was the Realty sector index which slipped 6.82 per cent. The Metal index slid 3.81 per cent and Auto index lost 3.33 per cent.
* BSE index falls 2.02 pct; NSE ends 2.09 pct lower
* India's volatility index surges on emerging market turmoil
* Glenmark shares gain; Oct-Dec earnings beat forecasts
Indian shares fall more than 2 pct in emerging markets rout
(Reuters) BSE Sensex slumped more than 2 percent on Monday, marking their biggest daily fall since Sept. 3 as a rout in emerging markets hit blue chips, while lenders were hurt further by caution ahead of the central bank's policy review.
The benchmark BSE Sensex index has fallen 3.1 percent since hitting a record closing high on Thursday, reflecting how sentiment has changed suddenly as the U.S. Federal Reserve is poised to continue reducing its monetary stimulus and as fears rise of an economic slowdown in China.
The global factors have raised fears that foreign investors will start exiting India after buying a net $20.10 billion of shares in 2013.
Foreign institutional investors sold shares worth 1.96 billion rupees ($31.37 million) on Friday but are still net buyers of 32.77 billion rupees this year.
Investors are also cautious ahead of the Reserve Bank of India's policy review on Tuesday.
Although analysts still think the Reserve Bank of India will keep interest rates on hold, expectations of a rate hike are increasing after the central bank made fighting high consumer inflation a priority.
India's NSE volatility index, considered at times as an investor fear gauge, surged 17 percent, reflecting the uncertainty.
"The market's reaction to the global contagion will be short-lived due to improvements in our current account. I think the RBI would support growth tomorrow and not just focus on inflation," said Deven Choksey, managing director at K R Choksey Securities.
The benchmark BSE index slumped 2.02 percent, or 426.11 points, to end at 20,707.45, marking its biggest daily decline since a 3.45 percent fall on Sept. 3 when domestic shares were hit by worries about military tensions in Syria.
The broader NSE index lost 2.09 percent, or 130.90 points, to end at 6,135.85, closing below the technically important 6,200 level.
Among blue chip shares, Reliance Industries fell 2.8 percent, while Larsen & Toubro (L&T) lost 2.6 percent.
Meanwhile, Tata Motors plunged 6 percent after the automaker's managing director, Karl Slym, died when he fell from a hotel room in Bangkok in what police said on Monday could be a possible suicide.
Ranbaxy Laboratories Ltd lost 8 percent, adding to Friday's 19.43 percent plunge, as the drug maker continues to reel after the U.S. drug regulator banned more of its products.
Among stocks that gained, Glenmark Pharmaceuticals Ltd rose 5 percent after the company reported better-than-expected earnings.
Opto Circuits surged 12.5 percent after a report said Goldman Sachs is likely to acquire a 26 percent stake in the Indian medical equipment maker for around 3 billion rupees, citing sources.
Opto officials were not immediately reachable for comments.
FACTORS TO WATCH
* Dollar touches 7-week low vs yen
* Brent eases towards $107 on China slowdown
* Emerging market anxiety hits Asian shares
* Foreign institutional investor flows