The top-30 BSE index dropped to its lowest close in more than 14 months, and registered its second quarterly fall in a row that took its losses for the half year to just over a third.
The fall was led by financial stocks on expectation for further monetary tightening to rein in inflation that hit 11.4 per cent in mid-June, its highest in more than 13 years.
Traders expected more pain ahead with inflation and oil showing no sign of weakening.
"It is a complete breakdown of confidence. The nervousness is quite high," said Deven Choksey, chief executive at brokerage KR Choksey.
Political worries intensified over the weekend after the left allies threatened to withdraw support from the ruling coalition if Prime Minister Manmohan Singh forged ahead with a US nuclear deal.
Oil, India's biggest import, rose to a record above $143 a barrel, propelled by heightened tensions between Israel and Iran.
"The short-term outlook for the Indian market remains bleak with the most challenging macro environment in years," Citigroup said on India in a research note.
The BSE index dropped 2.47 per cent, or 340.62 points, to 13,461.60, its lowest close since April 13, 2007, with 21 components in the red.
"With inflation unlikely to slow down, we expect benchmark Sensex to see a drop below 13,000 levels in the near term," brokerage India Infoline said in a research note.
The benchmark shed 18 per cent in June, the biggest monthly drop since May 1992. For the quarter, the index lost 13.95 per cent after falling 22.9 per cent in the previous three months.
"Panic is leading to further panic. We need some comforting words that suggests the fundamentals are still intact and inflation is being addressed to arrest this free fall," Choksey said.
In the broader market, 2,106 losers led 537 gainers on volume of 256 million shares.
The 50-share NSE index or Nifty fell 2.32 per cent to 4,040.55.
"Even as the near-term pain promises only to increase with sustained inflation... we believe that the economy retains its core strength and that equity valuations are quite favourable now that the froth has vaporized," Citigroup said.
Top listed firm Reliance Industries Ltd, which enjoys the heaviest weightage in the benchmark index, fell 4.1 per cent to 2,093.25 rupees on foreign fund selling, traders said.
No. 2 lender ICICI Bank ended 3.5 per cent lower at 630.20 rupees, its lowest close since September 2006. Top lender State Bank of India slid 4 per cent to 1,111.45, its lowest close in almost eight months. The BSE Bank index slipped 3.4 per cent.
Top mortgage lender Housing Development Finance Corp lost 4.4 per cent to 1,962.40 rupees.
Software exporter Infosys Technologies Ltd bucked the trend, rising 1.6 per cent to 1,734.75 rupees after the rupee weakened against the dollar. Higher-than-expected earnings reported last week by Accenture also helped.
Elsewhere in the region, the Karachi's 100-share index fell 0.52 per cent to 12,289.03, and Colombo's All share index dropped 0.51 per cent to 2,457.84.