The BSE Sensex and Nifty slipped more than 1 percent on Wednesday, falling for three out of four sessions as blue-chips including oil refiners slumped on concerns about the impact of higher oil prices on inflation and the government's finances.
The rupee slid 0.65 percent against the U.S. dollar and bonds also weakened.
Brent crude held above $113 per barrel on Wednesday as heavy fighting in Iraq shut the country's biggest refinery and led to the withdrawal of staff by foreign oil firms, stoking worries about exports from the key oil producer.
India imports 80 percent of its oil requirements and higher oil prices could make things more complicated for Prime Minister Narendra Modi who won last month's elections on promises of lower price rise, faster economic growth and new jobs.
"They have got hold of one refinery. Surging oil would either eat into India's balance sheet or fuel inflation. It may make life difficult for the new government and the RBI," said Nirakar Pradhan, chief investment officer at Future Generali India Life Insurance.
Asia's third-largest economy imports nearly 4 million barrels per day (bpd) of crude oil - of which more than half a million bpd come from Iraq.
The government expects oil prices to rise as high as $120 per barrel for several months because of fighting in Iraq, potentially driving a hole of at least 200 billion rupees ($3.3 billion) in the budget, two government sources told Reuters.
The Sensex lost 1.1 percent or 274.94 points to 25,246.25 after earlier falling as much as 1.6 percent
The Nifty fell 0.96 percent or 73.50 points to 7,558.20 after earlier slumping as much as 1.52 percent, also closing below the psychologically important 7,600 level.
The rupee touched a low of 60.43 to the dollar compared with its previous close of 60.03/04 and the 10-year benchmark bond yield rose 6 basis points on the day to 8.66 percent.
High oil prices and the recent spike in food inflation have pushed back hopes of interest rate cuts which added to the negative sentiment in bonds.
Falls also tracked weak global shares after a surprisingly high reading for U.S. inflation threatened to give a hawkish tilt to the Federal Reserve's policy outlook later in the session.
Among oil refiners, Bharat Petroleum Corp fell 3 percent, Hindustan Petroleum Corp lost 5 percent and Indian Oil Corp slumped 2.3 percent.
Oil explorers also fell on worries about a higher subsidy burden as crude oil jumps. Oil and Natural Gas Corp declined 0.5 percent, while Oil India lost 1.3 percent.
Reliance Industries fell 2.1 percent due to lack of any big announcements related to gas pricing and its telecom unit Reliance Jio Infocomm in its annual shareholder meeting, dealers said.
Among other blue-chips, HDFC Bank fell 1.4 percent while Larsen & Toubro lost 0.8 percent.
Tata Motors fell 1.8 percent while ICICI Bank ended 1.9 percent lower.
However, Cipla Ltd ended 2.9 percent higher after earlier rising as much as 7.3 percent to 443.25 rupees, its highest since Oct. 4, on speculation that the company's founders are in talks to sell their stakes to a global pharmaceutical company, multiple dealers said.
A spokeswoman for the generic drugmaker termed the rumour as baseless.