The benchmark Sensex index on the Bombay Stock Exchange closed down 258.78 points or 1.4 percent at a six-week low of 18,210.58 on concerns over the pace of economic growth and a stubborn rise in the cost of living.
"The markets are weighed down by inflation concerns, prospects of slowing growth and lower-than-expected earnings," said Bhaskar Kapadia, partner with Mumbai-based Pyramid Securities.
India's central bank, the Reserve Bank of India, on Tuesday hiked interest rates by a bigger-than-expected 50 basis points -- its ninth move in 15 months -- to 7.25 percent.
Policy makers are trying to rein in spending, with annual inflation now nearing nine percent, making it the highest for any major Asian economy.
Inflationary fears have also seen foreign funds turn bearish, selling equities worth $480.58 million in May. In 2010, overseas funds pumped a record $29 billion into Indian equities.
On Thursday, government statistics showed the food price index rose 8.53 percent while fuel inflation was 13.53 percent in the year to April 23.
The markets were also weighed down by central bank forecasts of eight percent annual growth this fiscal year, down from an earlier projection of 8.5 percent.
Central bank governor Duvvuri Subbarao has said his priority is curbing inflation, even at the expense of slowing growth in the short term.
-- Dow Jones Newswires contributed to this report --