The sentiment further dampened after the rupee slipped past the 63-mark versus dollar as a rout in emerging market currencies continued. Reports said Argentina abandoning support of its peso on the open market affected investors.
After opening nearly 235 points lower, the BSE 30-share Sensex remained in the negative terrain throughout the day.
It touched a low of 20,688.03, before settling at 20,707.45, a drop of 426.11 points or 2.02 per cent compared to Friday's close. This was the biggest drop since the 651.47-point plunge on September 3, 2013.
ICICI Bank and HDFC Bank led 27 losers in Sensex lower. Tata Motors and Tata Steel slid by over 6 per cent each.
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A bout of uncertainty has gripped investors, especially those betting on rate-sensitive banking, auto and realty, after the RBI Governor Raghuram Rajan called inflation a "destructive disease" last week. Hopes of a rate cut had faded after a panel recommended making retail inflation a priority.
"...There is an anticipation in the market that RBI will keep its interest rates high in spite of some corrections seen in the inflation numbers," said Jignesh Chaudhary, Head Of Research, Veracity Broking Services.
All 12 BSE sectoral indices ended in the red.
Profit-booking by wary investors ahead of the expiry of January equity derivative contracts on Thursday was also one of the factors responsible for the down-trend.
The 50-issue NSE Nifty tumbled by 130.90 points, or 2.09 per cent, to settle at one-month low of 6,135.85.
"Markets in India fell sharply largely due to the weakness in global markets and ahead of RBI meeting tomorrow. Concerns over the contagion from emerging markets like China and Argentina kept sentiments subdued," said Dipen Shah, Head- Private Client Group Research, Kotak Securities.