The fall came after the stock market regulator proposed urgent curbs on the flow of foreign funds into shares to stop the market overheating.
The Sensex sank to 17,544.15, after Tuesday's record high of 19,174.45, while the rupee also lost value. Trading resumed in mid-morning.
India's finance minister said that there was no need for alarm.
'Abundant investment'
The regulator's recommendation relates to participatory notes - a form of investment used by hedge funds and other foreign investors who are not registered in India.
The notes present problems such as uncertainty over who is putting money into Indian companies.
Finance minister P Chidambaram said that foreign investment was still welcome.
"But presently it is important to moderate capital flows, which are getting very copious and abundant," he said.
Analysts at JP Morgan suggested that of the $17bn of foreign funds invested in India so far this year, about $10bn has been in participatory notes.
"Investor sentiment is likely to weaken considerably as an important source of potential inflows has likely been plugged," said Rajeev Malik, an economist at the firm.
India is seen by many investors as one of the safest havens among the emerging markets as investors try to tap into one of the world's best-performing economies.
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