The BSE Sensex fell more than 2 percent on Monday, with the Nifty retreating from a near 2-1/2 year high and ITC slumping from a record high, as investors viewed a recent four-week rally as excessive after data showed a jump in the trade deficit.
A 138 percent jump in gold imports last month lead to a surge in India's trade deficit, raising concerns about the current account deficit and offsetting any comfort policymakers took from slowing inflation.
Weaker Asian shares also weighed on sentiment after China posted surprisingly feeble factory output growth, while fixed-asset investment slowed.
Shares have gained 7.8 percent since mid-April, spurred by a rally in the global markets, as easier monetary policies among major central banks raised the prospects of increased foreign inflows.
Analysts said they expected stocks to remain supported by that global liquidity, although economic indicators - including wholesale price due on Tuesday - and political developments ahead of elections expected by next year would also be key.
"Purely on account of international liquidity, we have seen massive inflows and markets have been rallying for the past few weeks," said Kaushik Dani, fund manager Peerless Mutual Fund.
"For me it is more of a correction that was due for quite some time since the rally was quite ahead of fundamentals," added Dani.
2.14 percent, or 430.65 points, to end at 19,691.67, marking its biggest daily percentage fall since May 2012, and retreating after ending on Saturday at its highest close since January 6, 2012.
The broader Nifty fell 2.08 percent, or 126.80 points, to end at 5,980.45, retreating from its highest close since January 2011.
Foreign institutional investors have been net buyers for 15 consecutive sessions, bringing their total investment for the year to $12.70 billion, regulatory data shows.
Until Monday, those purchases had helped send Indian shares higher.
"Nifty may fall to 5,900 on profit-taking, but it's a buy-on-decline market given the liquidity in the global context," said Deven Choksey, managing director at KR Choksey Securities.
ITC Ltd slumped 5.2 percent, marking its biggest single-day fall since September 2012 and retreating from an all-time high hit on Saturday, when markets were opened for a special trading session.
Dealers cited caution ahead of the cigarette maker's January-March earnings due on Friday as well as speculation ITC's weighting may be reduced by index compiler MSCI, which is expected to announce its semi-annual review this week.
ITC shares had gained 7.7 percent in May, as of Saturday's close.
Technology stocks such as Tata Consultancy Services Ltd fell as the U.S. Senate debates a U.S. immigration bill that analysts say could hurt Indian companies by making the sponsoring of visas more difficult.
TCS fell 2.6 percent, while Infosys Ltd declined 1 percent.
ICICI Bank Ltd , HDFC Bank Ltd and Axis Bank Ltd fell over 1.3 percent each after news channel CNBC-TV18 reported the Reserve Bank of India has found some violations on Know Your Customer rules by the lenders, citing unnamed sources.
All three banks declined comment.
DLF Ltd fell 2.1 percent after it said in a statement late on Saturday that the company will sell about 81 million shares in a price band of 222 rupees to 233 rupees each.
Essar Oil Ltd fell 5.9 percent after Credit Suisse downgraded it to "underperform" from "neutral", citing "high" debt gearing, higher valuations than regional peers and cash flow concerns.
Among stocks that gained, Jubilant Foodworks Ltd rose 1.8 percent as recent losses on disappointing March-quarter earnings were seen as overdone.
(Additional reporting by Himank Sharma; Editing by Anupama Dwivedi)