The BSE Sensex fell as much as 595.21 points before ending 382.93 points lower, or 1.85 per cent, to 20,263.71. It was the biggest drop since a 651-point decline on September 3.
The index had yesterday surged 684 points to an almost three-year high after the US Federal Reserve left its stimulus programme unchanged.
The NSE Nifty plunged 103.45 points, or 1.69 per cent, to 6,012.10. Also, MCX-SX's 40-share index ended at 12026.41, down 205.69 points.
RBI Governor Raghuram Rajan, in his maiden policy review, unexpectedly hiked the repo rate or the short term lending rate by 25 basis points to 7.5 per cent with immediate effect in a bid to control inflation.
The forex market also reacted negatively and the rupee depreciated 85 paise to 62.62 to the dollar intra-day.
Interest-sensitive sectors such as realty and banking were the major losers as a higher cost of credit would hamper their business and reduce revenue.
The realty sector index dropped the most, losing 6.53 per cent, followed by the banking index 4.18 per cent, the capital goods index 3.04 per cent and the auto index 1.58 per cent.