Investors have fled from the markets as Italy's borrowing costs surged into "bailout territory" and thrust the country into the heart of the eurozone debt crisis.
The FTSE 100 Index was 1.6% lower as the yield on Italian 10-year bonds rose from 6.37% to a euro-era high of 6.64% - a sign investors are losing confidence in the country's creaking finances.
The rise - which came amid increased political uncertainty in Italy, as Prime Minister Silvio Berlusconi prepares for a crunch vote on public finances - prompted fears that Italy would follow Greece, Ireland and Portugal in needing a bailout from the EU and IMF.
Kathleen Brooks, research director at Forex, said: "It's hard to see how investors can live with Italy on the cusp of a bailout, so risk is likely to remain under pressure in the near term."
The developments in Italy, which is the eurozone's third-largest economy and has debts worth 120% of national income, pulled focus away from Greece, where Prime Minister George Papandreou resigned.
The banking sector was once again hit by fears of its exposure to sovereign debt with Lloyds Banking Group down 4% and Barclays and Royal Bank of Scotland off more than 3%.
Elsewhere in Europe, Germany's Dax and the Cac-40 in France fell more than 1.5%.
The surging borrowing costs in Italy are the latest twist in the ongoing debt crisis in Europe, which has dominated the markets for weeks.
Ms Brooks said the outcome of Tuesday 's vote in Italy - which is also viewed as a confidence vote in Mr Berlusconi - was key to how the markets performed this week.
She said: "The result of this vote will be crucial for risky assets, a no vote could see Italian bond yields surge and the euro and other risky assets plummet."
© 2011 Press Association