The benchmark Sensex fell below the 13,000 mark for the first time since December 13, 2006, but recovered marginally to close at 12,938.09, down by 4.01 per cent on the previous closing.
The broader CNX Nifty of the National Stock Exchange (NSE) also slumped by 3.8 per cent or 149 points to end the day at 3,745 levels.
The biggest losers were the information technology, cement and metal stocks.
Analysts said the steep fall in the markets was both due to the global trend and investor disappointment with the federal budget presented in Parliament on Wednesday.
Finance Minister P Chidambaram announced higher allocations for education, health and various incentives for the farm sector but little little to cheer industry in his budget for 2007-2008.
The decline in global markets was triggered by a major slide in the Chinese stock market. Most Asian, European and United States markets also witnessed heavy sell-offs.