The blue-chip FTSE 100 closed down 0.5 percent, or 28.93 points lower, at 5,925.37 points, marking its worst intraday fall since losing 0.6 percent on November 26.
Traders said uncertainty over talks in the United States to avoid a "fiscal cliff" - a combination of government spending cuts and tax rises due for early next year which could hit the U.S. economy - was the main reason for the fall.
However, most investors still felt U.S. politicians would reach an agreement to avoid the "fiscal cliff". They said that even if a deal was not reached by the end of December, an agreement was likely to be struck in early January.
"It's still worth staying invested in equities and not worth worrying too much," said SVM Asset Management managing director Colin McLean.
"I don't think there'll be much of a sell-off, provided they can come up with something within the next 10 days," he added.
DECENT GAINS FOR 2012
Uncertainty over the U.S. budget situation has prevented the FTSE 100 from rising beyond the 6,000 point mark - a level seen by technical traders as key to propelling further moves higher.
"I think there's going to be some resolution on the cliff but they're running out of time," said a European equity options broker who declined to be named.
However, the FTSE 100 is still up by 6 percent since the start of 2012, although it has underperformed gains of 30 percent on Germany's DAX and a 15 percent rise on France's CAC-40 index.
The outperformance of the German and French markets has been partly driven by a surge in euro zone equities after the European Central Bank pledged new measures to tackle the euro zone's sovereign debt crisis.
Nevertheless, investors remain upbeat on prospects for UK shares in 2013, with a Reuters poll this month forecasting that the FTSE 100 would end 2013 at 6,400 points.
Cavendish Asset Management fund manager Paul Mumford added that many investors favoured equities over bonds or cash, due to the better returns on offer from stock dividend payouts.
The move by central banks to cut interest rates to record lows, in order to fight off the effects of the fragile global economy, has hit returns on cash and benchmark government bonds, whereas dividends typically offer more.
According to Thomson Reuters Starmine data, the UK stock market has an estimated dividend yield of 3.8 percent for the next 12 months - more than yields of 1.8 percent on 10-year UK government bonds.
"All in all, I take a favourable view of the outlook. In 2013, people will be looking for yield, and you're not going to get it from bonds," said Mumford.